CHAPTER 3: FACTORS INFLUENCING REVENUE RESILIENCY

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1 CHAPTER 3: FACTORS INFLUENCING REVENUE RESILIENCY SERVICE AREA SIZE AND DIVERSITY Introduction Perhaps one of the most generalizable determinants of utility financial performance is facility size and customer base. Larger utilities can take advantage of economies of scale and spread their costs (which are mostly fixed) over a greater number of customers, thereby reducing costs per account. Smaller utilities have many of the same fixed costs and requirements with fewer customers to cover costs. Additionally, utility staff may lack time and expertise to strategically finance their utility. Larger systems are also more likely to have a diverse customer base (i.e. a healthy mix of residential, commercial, industrial, and wholesale customers) and are less vulnerable to revenue fluctuations as a result of individual customer behavior change. The following chapter explores utility financial trends in the context of service size area and diversity. Key Points Utilities serving a larger customer base tend to have lower rates and stronger financial performance metrics than their smaller counterparts. Water utilities have very different customer type diversity profiles with some utilities almost exclusively relying on residential customers and others with a broader non-residential and residential mix. Utilities with a larger percentage of industrial or wholesales tend to have stronger financial metrics. On the other hand, utilities reporting a reliance on a small number of very large customers are more at risk of sudden revenue drops due to the loss of one or two customers. System Size Figure 3.1 reiterates the notion that larger utilities are generally more financially secure than smaller utilities; it shows larger utilities tend to have higher operating ratios. In the 2012 AWWA-RFC Water and Wastewater Rates Survey, none of the utilities serving more than 150,000 accounts reported having operating ratios less than 1.0 (an indication that operating revenues fell short of operating expenses), a fate that several smaller systems did report. 77

2 Figure 3.1 Operating ratio and number of accounts for 286 utilities nationwide in 2012 The AWWA-RFC survey sample has a disproportionate number of large systems in its sample. An analysis of statewide data provides additional insight into the financial challenges of smaller systems. In North Carolina, 34% of local government utilities serving fewer than 1,000 connections had greater debt service and operations and maintenance expenses than the total operating revenues they collected from customer charges in FY2012, as shown in Table 3.1. In fact, 17% did not collect sufficient revenue in that fiscal year to pay for their day-to-day expenses alone. By comparison, only 8% of utilities serving more than 10,000 connections had debt service and operation and maintenance expenses that exceeded operating revenues. These financial stressors carry over to rate setting such that even though they are more likely to be suffering losses, smaller systems are also more likely to have higher rates than larger utilities as shown in Table 3.2. Table 3.1 Utility financial performance in FY2012 among 382 local government utilities in North Carolina, by utility size Number of service connections Number of utilities Operating revenues insufficient to cover operations and maintenance expenses Operating revenues insufficient to cover operations and maintenance expenses plus debt service Operating revenues sufficient to cover debt service and operations and maintenance expenses % 17% 66% 1,000 9, % 21% 74% 10, % 8% 92% Source: Adapted from (Eskaf et al. 2013) 78

3 Number of accounts Table 3.2 Median water and wastewater monthly bills in North Carolina in 2013, by utility size Number of Median water Number of Median wastewater water rate bill for 5,000 wastewater rate bill for 5,000 structures gallons/month structures gallons/month $ $ ,000 2, $ $ ,500-4, $ $ ,000 9, $ $ ,000 24, $ $ , $ $34.81 Source: Adapted from (Eskaf et al. 2013) Utilities in growing regions are able to spread the costs of capital expansions and debt service over an ever-larger customer base. The increasing economies of scale associated with such expansions mean that utilities in these environments are very likely to see consistent increases in financial health. In shrinking regions, by contrast, utilities are likely to find themselves stuck servicing a fixed amount of debt and short-term fixed costs with a stagnant or worse, declining, revenue base. Utilities in this position are likely to face severe financial challenges. Data from the national AWWA-RFC Water and Wastewater Rates Surveys show that during the period of 2000 to 2012, utilities that experienced increases in the number of accounts experienced higher operating ratios (Figure 3.2), which does not account for an increase in non-operating revenues associated with a growing system. Figure 3.2 The change in the number of accounts versus non-capital operating ratio reported in 2012 among 114 utilities nationwide 79

4 Diversity of Customer Base The concept of customer or market diversity comes up in any discussion of financial resiliency; the utility sector is no exception. Most utilities provide different types of services (water, irrigation water, wastewater, supplemental services) to several types of customers: single-family residential, multi-family residential, commercial, industrial, institutional, and other utilities (wholesale service). The relative share of a utility s sales consumed by different customer sectors can affect the utility s revenue and costs, and the vulnerability of its revenue generation to customer demand fluctuations. An analysis of data in North Carolina illustrates potential revenue vulnerability for utilities that generate a significant amount of revenue from a small number of (usually non-residential) customers are more susceptible to revenue loss than utilities that spread their revenue generation across a greater number of customers. During 2010, 5% of 255 North Carolina utilities reportedly generated more than half of their total annual revenues from their five single largest customers (Figure 3.3, adapted from Eskaf, Hughes, and Nida 2011). If any one of these five customers left town, the utility would generate much less revenue in the subsequent year without a corresponding decrease in costs since the majority of expenses are fixed at least in the short-term. Source: (Eskaf, Hughes, and Nida 2011) Figure 3.3 Breakdown of 255 North Carolina utilities based on the percentage of the utility s total annual revenues generated by the 5 largest customers Utilities that operate as wholesale-only (as opposed to retail) utilities often are under the same pressure as utilities with a large dependence on a few industrial customers. Wholesale utilities, such as the Metropolitan Water District of Southern California, sell water exclusively to surrounding utilities and do not provide direct water service to residential or commercial customers. Their revenue stream is sensitive to fluctuations in purchases from other utilities. Because their purchasing utilities may implement policies that affect demand (by implementing conservation-oriented rates, for example), wholesale utilities may have less control than retail utilities over their water demands, sales, and financial condition, although they have the option to address this issue in contracts. 80

5 Local Water Supply Plan (LWSP) data from North Carolina Department of Environment and Natural Resources and financial performance data from the North Carolina Local Government Commission shows the variation in the importance of industrial sales across the state. A utility whose revenue largely comes from one or two large customers are subject to similar revenue vulnerability as wholesale utilities. However, despite the potential for more severe revenue fluctuation due to the loss of large customers, many utilities with a more diverse customer base that includes large industrial users have historically performed relatively well in North Carolina. While the trend is fairly weak, Figures 3.4 and 3.5 show that water utilities that sold a greater percentage of their output to industrial customers and to other utilities, respectively, tended to have higher operating ratios than those with lower sales to those types of customers. This trend may be due as much to the challenges facing utilities that focus on residential customers as it is to the inherent stability of depending on industrial customers. Figure 3.4 Operating ratios of 363 North Carolina utilities by share of water sales to industrial customers 81

6 Figure 3.5 Operating ratios of 363 North Carolina utilities by share of water sales to other utilities References Eskaf, S., D. Tucker, D. Batten, A. Patel and C. Nida Water and Wastewater Rates and Rate Structures in North Carolina, January Chapel Hill, N.C.: NC League of Municipalities and the Environmental Finance Center at the University of North Carolina. [Online]. Available: < [cited May 31, 2013] Eskaf, S., J. Hughes and C. Nida Results of the 2010 North Carolina Water and Wastewater Financial Practices and Policies Survey. Chapel Hill, N.C.: NC League of Municipalities and the Environmental Finance Center at the University of North Carolina. [Online]. Available: < [cited May 31, 2013]. WATER USE AND WEATHER Introduction Under the prevalent pricing models of water utilities across the United States and Canada, customer water use patterns have a very strong influence on utilities revenues and, by extension, on utility financial performance. Conversely, many utilities have incorporated pricing into their tools for impacting use. Understanding and managing this price-usage nexus is critical for utility managers that navigate between conservation goals and revenue requirements. As explained in the Trends in Utility Finance section, commodity charges generate revenue directly from the volume of water sold and are often the main source of revenue for water and wastewater utilities. When sales fall, revenues typically fall with them. But a decrease in water sales, however, does not lead to a commensurate reduction in utility expenses (further explained in the Trends in Utility Finance section). Without constant attention to pricing levels and structures, consistent decreases in water use from year to year can lead to significant revenue shortfalls for utilities. While many utilities have an expressed goal of reducing water usage, excessive declines in water use over recent years have caught many utilities off-guard, as 82

7 revenues have fallen below predicted levels. As significant a significant driver of water use, weather can compound the relationship and its predictability, particularly in a time of climate extremities Key Points Water use for many utilities is the defining characteristic in the revenue consistency (and sometimes health) under current pricing and finance models. National trends indicate that average water use per capita and per account is generally decreasing over time. These trends corresponded with increasing drought trends across the country. Droughts in the United States were more significant in , , and from 2011 onwards, when at least 10% of land was in extreme or exceptional drought. Such high drought prevalence is indicative of the need for utilities to develop revenue response strategies in conjunction with water shortage response strategies to help maintain utility financial health in times of restrictions. Detailed analysis of large datasets of utilities within two states in separate regions of the country (NC and TX), show variation across utilities and regions that reinforces the danger of relying on generalized assumptions. o In North Carolina, long-term trends of declining average residential use are more apparent than short-term fluctuations. Within North Carolina, utilities experienced extreme fluctuations in sales trends suggesting differences underlying factors from the implementation of water efficiency to customer migration. o Although average residential water use declined for slightly more utilities than not, the Texas municipalities in this analysis were almost evenly split between those that reported increasing average residential water use and those that reported it decreasing. These trends have a direct impact on the water pricing, and vice versa. Understanding the pricing-usage nexus should be a leading component of revenue projection. National Trends Literature on water use trends shows a convincing trend of increasing water use efficiency across the country. A look at four end use studies since 1995 shows that indoor residential water use was observed to be between 13.3% and 42.7% lower for a family living in a highly efficient new home (DeOreo and Mayer 2012). In another study, when controlling for weather and other variables, households in 2008 used nearly 12,000 gallons less annually than an identical household in 1978 (Rockaway et al. 2011). The overwhelming evidence, from research presented both here and elsewhere, supports a general trend of decreasing water consumption over the last decade, although regional differences may exist. The national AWWA-RFC Water and Wastewater Rates Surveys, conducted biennially from 2000 to 2012, collected data on daily water sales in million gallons per day (MGD) and the number of water accounts for hundreds of utilities across the United States. Daily water sales included the aggregated utility-wide water sales to all customer types, including residential, commercial, industrial, institutional, and wholesale. Of the utilities that responded, 69 utilities in 32 states provided data on daily water sales and the number of water accounts in every survey from 2004 through Figure 3.6 displays the median daily water sales and median number of water accounts in this cohort of 69 utilities between 2004 and While the number of water accounts increased over time due to population and customer base growth, the utility-wide median daily water sales decreased steadily over time (an 8.7% reduction from 2004 to 2012). This means that although the number of 83

8 customers increased, the total water demand decreased over time for at least half of the 69 utilities. In fact, 47 out of the 69 (68%) utilities had lower daily water sales in 2012 compared to 2004, even though 60 out of the 69 (87%) utilities gained water customers during that time period. Declining total sales translates directly to lower revenues for utilities. To compensate, utilities would have had to raise rates in order to avoid declining revenues. Figure 3.6 Daily water sales and number of water accounts among 69 utilities nationwide from 2004 to The overall trends shown in Figure 3.6 were not seen for every individual utility studied. Figure 3.7 shows very different trends among utilities in the dataset. The degree to which daily water sales changed over time is shown in Figure 3.7, which compares daily water sales in 2012 to water sales in 2000 and 2006, in order to check in on the consistency of the trend. The analysis shows that despite a widespread increase in the number of water accounts, the majority of utilities had lower total daily water sales in 2012 than both comparison years. Using the years 2000 to 2006 as a baseline, 63% and 60% of the surveyed utilities, respectively, saw a reduction in total water sales when compared to In almost any industry, lowering sales of a product by more than 25% can be devastating to revenues, and such is the case for the water utilities as well. Although there are a number of factors explored later in this report that could have been driving this change in one particular year (2012), the point is that, despite why, sales declined for the majority of utilities. 84

9 Figure 3.7 Differences in water sold and number of accounts in 2012 compared to the past decade Regional Trends These national trends indicate that average water use per account is generally decreasing over time. At the regional level, however, results varied, implying that there may be regional trends that contradict the overall, national trends. In this analysis, the average residential water use data for larger samples of utilities in North Carolina and in Texas two geographically disparate states with different climates are compared. Data on water use in North Carolina were obtained from the North Carolina Division of Water Resources Local Water Supply Plans, which are plans in the form of questionnaires that all local government and large community water systems are required to complete. The LWSPs were completed in 1997, 2002, 2007, and updated once a year since then. The questionnaires asked water systems to report their average daily use (sales) in MGD and the number of metered connections, by customer class. From these data, the average household water use was calculated for this analysis in gallons/month. For Texas, hundreds of municipal water utilities directly reported their average residential water use, in gallons/month, to the Texas Municipal League as part of their annual Water and Wastewater Rates Surveys. For both states, analyses are presented on the changing average household (residential) water use in gallons/month, and not at the aggregated, utility-wide total sales in MGD. In North Carolina, average residential water use has been declining steadily in the past decade. Figure 3.8 tracks the median and interquartile range of average residential water use among a cohort of 217 water systems in North Carolina for which data were available in every year. The median decreased from 5,083 gallons/month in 1997 to 4,292 gallons/month in On the low end, 38% of these systems average residential use was lower than 4,000 gallons/month in 2010, up from 19% in

10 Figure 3.8 Average household water use among 217 water systems in North Carolina from 1997 to 2010 The extent of declines in average water use for 436 water systems in North Carolina is shown in Figure 3.9. Average household water use in 2010 was lower than water sales in all previous years, except in 2009, for more than half of the water systems, with greater proportions of water systems experiencing declining average residential demands over longer periods of time. A total of 70% of water systems average residential demands declined between 1997 and In more recent years, 15% of water systems reported that average residential water use declined by more than 25% between 2007 and 2010 a span of only three years. One factor that might have influenced this decline is a severe drought that occurred in during which many utilities across the state initiated water conservation programs. A recent study by the Environmental Finance Center at the University of North Carolina found that 10-15% of households (out of 316,000 studied) more than halved their water use in those three years (Boyle et al. 2012). On the other hand, a sizeable portion of water systems reported increasing average residential water use in recent years, although these portions are consistently smaller than the percentage of water systems reporting declining average uses. Long-term trends of declining average residential water use are more apparent than the short-term fluctuations. 86

11 Figure 3.9 Average monthly residential water use in 2010 relative to previous years (n=436 water systems in North Carolina) As could be expected given differences in climate, weather, water-use culture, and economic conditions, trends in average residential water use in Texas were different. Although average residential water use declined for slightly more utilities than not, the Texas municipalities in this analysis were almost evenly split between those that reported increasing average residential water use and those that reported it decreasing. Following a cohort of 116 Texas utilities that reported their average residential water use every year between 2002 and 2012 indicates that the trend neither decreased nor increased for a majority of the utilities (Figure 3.10). In fact, the median and interquartile ranges for the 116 utilities remained almost unchanged throughout the entire ten year period. That is not to say that none of the utilities in this cohort reported any changes in their average residential water use; just that there were nearly equal number of utilities that witnessed mirror opposite changes in their averages during those years. Furthermore, the uniformity of data may indicate a concern about the quality of the self-reported data on the surveys. 87

12 Figure 3.10 Average residential water use among 116 municipalities in Texas from 2002 to 2012 Figure 3.11 displays the changes in average residential water use between 2002 and 2012 for 423 Texas utilities. Based on the self-reported data, average residential water use declined for a larger portion of utilities between 2002 and

13 Percentage of 423 Texas Municipal Water Utilities 25% 20% 15% 10% 5% 0% 3% 11% 8% 17% 8% 23% 17% 11% 3% Figure 3.11 Percentage changes in average household water use for 423 Texas municipal water utilities, (self-reported) When analyzed on a year-to-year basis, Texas utilities were more likely to report stable or increasing water use trends, especially in later years, than were their counterparts in the national and North Carolina data sets, reinforcing the importance of trends in water use practices across the country. For example, in many parts of Texas, outdoor watering around the foundation of a house is viewed as an essential water use to prevent structural foundation damage due to rapidly shrinking and shifting clay soils. This water use practice may be viewed differently than outdoor watering in other parts of the country to maintain green grass. Furthermore, the median average residential water use in Texas is higher than it is in North Carolina: about 6,000 gallons/month versus less than 4,500 gallons/month, respectively. Analysis shown in the Trends in Pricing section indicate that water rate increase amounts and frequencies are very similar in Texas and North Carolina, implying that rate increases may not be the driving factor for the differences in water use trends between the states while variations in the climate and water availability in the two states likely are, in addition to other regional differences. The Impact of Weather and Droughts A major external driver behind customer water demand (and ultimately utility revenues) is weather. In suburban communities where residential and non-residential customers irrigate lawns and landscapes during the summer, the seasonal demand for water is highly dependent on precipitation and temperature patterns. During rainy summers, customers are likely to significantly curtail their outdoor water demand. In summers with warmer temperatures than normal, water demand might increase as customers use more water for cooling towers, irrigation, filling swimming pools, etc. The relationship between precipitation, temperature, and water demand are not always clear cut, though, since different 89

14 combinations of precipitation and temperature patterns may affect customer demands in unpredictable ways. Nonetheless, utilities in which water demand cycles with the seasons will usually find that highseason water demands, and therefore water sales, will vary from year to year at least partly in accordance to weather patterns. To complicate the relationship even further, long-term weather patterns and climate change may create changing conditions that affect customer demands for some utilities. One way long-term trends in precipitation and temperature manifest themselves at the local level is in creating droughts. During droughts, water demand patterns will change. On the one hand, temperatures and precipitation patterns during droughts are usually such that water demand increases as customers purchase more water for irrigation and cooling purposes. This was recognized in the Fitch Ratings Special Report on the financial impact of Texas 2011 drought, for example, reporting that droughts can improve the financial conditions of utilities with ample supplies that do not have to enact water use restrictions because customer demands increase, leading to greater revenues (Scott et al. 2011). On the other hand, when droughts sufficiently diminish utilities water supplies, utilities often attempt to lower their customers demands through conservation programs, pricing, and userestrictions in order to ensure sufficient water resources are available for the most basic needs of all customers. By implementing demand-side management strategies, utilities may be successful in lowering customer demands during water shortage periods, but the decreasing demands translate to decreasing revenues for the utilities. As explained previously, the majority of the utilities expenses, at least in the short-run, are fixed while the majority of revenues are obtained from the commodity charges. As customers conserve, utility revenues decline much faster than utility expenses. Some utilities may offset the revenue losses due to conservation during water shortage periods by implementing drought surcharges. Overall, therefore, droughts and long-term weather may affect utilities finances either positively or negatively, depending on local conditions. Across the United States, drought conditions are assessed and monitored weekly in the U.S. Drought Monitor, which is produced in partnership between the National Drought Mitigation Center at the University of Nebraska-Lincoln, the United States Department of Agriculture, and the National Oceanic and Atmospheric Administration (U.S. Drought Monitor 2013). The Drought Monitor synthesizes multiple indices that measure drought conditions using historic weather data into a single, categorical value: Normal: no drought D0: abnormally dry D1 drought: moderate D2 drought: severe D3 drought: extreme D4 drought: exceptional 90

15 Figure 3.12 shows the percentage of area in the United States and Puerto Rico under various levels droughts weekly between January 2000 and February During this 12 year period, 7% - 55% of the area was in D1 D4 levels of drought in any one week. Droughts were more significant in , , and from 2011 onwards, when at least 10% of land was in extreme or exceptional drought. Such high drought prevalence, particularly for extreme droughts, is indicative of the need for utilities to develop effective water shortage response strategies (and corresponding revenue response strategies) that will help maintain utility financial health in case conservation programs are enacted. Figure 3.12 Percent area in the United States and Puerto Rico in different stages of drought between January 2000 and February 2013 Water Use, Rates, and Revenue Could increasing water prices also be behind the nation s shift in water demand? Although Consumer Price Index increased by only 22% between 2004 and 2012, a national cohort of utilities raised rates by a median 50% during that same time period. Likewise, our research indicates that the majority of utilities in six states have been raising rates faster than the rate of inflation in recent years. Though many of the utilities are likely raising rates to shore up their financial position and/or to promote conservation through pricing, it is also possible that the rate increases have been both a cause and a result of decreasing consumption. As water use falls, if rates and pricing structure is not altered, revenues decline substantially faster than utilities costs, which are mostly fixed. In a falling use environment, utilities must raise customer s bills and unit prices to maintain revenue generation at a level sufficient to pay for the (mostly fixed) costs of the utility. These higher rates, in turn through price elasticity, increase the financial incentive for customers to conserve, leading to further water use declines. The magnitude of this effect is highly dependent on the price elasticity of demand for drinking water. The more a utility raises its rates, the more price sensitive customers may become when their water and wastewater 91

16 charges comprise larger portions of their monthly budgets. Utilities must therefore be careful in using rate increases to cope with lost revenue from falling consumption. If rate calculations do not take into consideration falling usage adequately, the utility may be forced to implement additional unplanned for rate increases. If water rates do not go up, declining use might be expected to take water utility revenue with it. Figure 3.11 graphs the change in average water use per-account versus the percent change in operating revenues per account for 96 utilities between 2010 and The analysis shows a definite positive correlation between changes in average water use and changes in operating revenues. But it also shows that revenues have been partly resilient to water use. In many cases, revenue changes were above the 1-to-1 line, indicating that changes to operating revenues were greater in value than changes to average water use. This is good news for utilities. A 10% decline in average water use results in less than a 10% decline in revenue. Although, there were a few utilities whose increases in average water use did not seem to drive corresponding increases in revenues. Conclusion Whether the result of changes in rates, weather, household size, efficiency policy, economic realities, or a combination of all and then some, lower levels of water use per customer is likely to represent a new normal for water utilities. It may be unlikely for water use to return to prior levels, given the ever-increasing efficiencies of water appliances and fixtures, and due to continual pressure to conserve both due to ever-increasing rates and a growing conservation ethos among customers. Data indicate that water use declines have been occurring for several years. In the long-run, these reductions are beneficial to the utility and to the environment, putting less stress on existing water resources, lowering power and chemical uses and costs, delaying the need for expanding water resource supplies, freeing current supplies for future customers, and preserving water resources for environmental uses. However, because demand is closely linked to utility revenue, low levels of water use in the short-run are likely to create the largest financial challenge facing water and sewer utilities in the coming decade. Our analysis shows that in the recent past, utilities have been able to maintain and even increase revenue levels despite trends in declining demand. Regardless, future strategies should focus on maintaining revenue stability and financial solvency in the context of lower demand. At the very least, utilities should strive for detailed, integrated, and updated demand forecasts (explained in the Strategy Section of this report) when projecting costs and revenues and setting rates for upcoming years. References Boyle, C. M. Tiger, M. Ngo, S. Eskaf and C. Wichman Shifting Baselines in Water Management: Using customer-level analysis to understand the interplay between utility policy, pricing, and household demand. Chapel Hill, N.C.: Environmental Finance Center. [Online]. Available: < [cited May 23, 2012] DeOreo, W.B. and P.W. Mayer Insights into declining single-family residential water demand. Jour. AWWA, 104(6): Rockaway, T.D., P.A. Coomes, J. Rivard and B. Kornstein Residential water use trends in North America. Jour. AWWA, 103(2): Scott, D., G. Gutierrez, J. Seebach, and T. Wenck Fitch Ratings Special Report: Texas-Sized Drought for the Lone Star State. New York, N.Y.: Fitch Ratings. U.S. Drought Monitor Current U.S. Drought Monitor. [Online]. Available: < > [cited February 16, 2013] 92

17 ECONOMIC CONDITIONS Introduction The water and wastewater industry has long relied on the conventional wisdom that everyone needs water services, and that while the cost is increasing, the services are still priced at reasonable enough levels that customer ability-to-pay is not a major hurdle to resiliency of the existing business model. This section includes an analysis of the economic conditions facing residential and nonresidential water and wastewater customers to characterize the stress changing economic conditions may be placing on revenue generation for utilities. Economic conditions have the potential to influence a utility s financial condition in a number of different ways. As issuers of debt and consumers of goods and services, utilities expenses are subject to economic conditions, through changing availability and terms of debt and changing prices of labor and materials. But economic conditions can also influence utility revenues. When residential customers experience economic difficulties through declining income and rising unemployment, their ability to pay for water and wastewater services diminishes and the customers may be more likely to reduce their expenditures on these services through reduced consumption. Likewise, commercial and industrial customers that are negatively affected by economic conditions may seek to cut costs by reducing water consumption or even installing wells to lower their water expenditures. In worst cases, a decline in the economic conditions may force small businesses and industries to close or leave town, completely eliminating their portion as a source of revenue to the water and wastewater utility. As shown in the Service Area Size and Diversity Section, some utilities rely heavily on their largest five customers for a substantial portion of their total revenues; should one or two of these customers leave, the utility will be hard-pressed to make up the loss in revenues from their other customers. Additionally, a slowdown in the growth in a utility s service area means that there will be fewer new customers that would connect to the utility and pay the connection (tap) and system development (impact) charges, deposits, account activation charges, etc. (Although, the loss of these revenues may be offset by a reduction in the expenses of extending pipes to those new customers.) In addition to driving down demand and growth-associated revenue, a weak economy can negatively influence a utility s capacity to increase pricing. In a special report, Standard & Poor s observed that the annual increase in water utility rates far outpaced even the most optimistic projections in the change of real disposable income (Chapman, Breeding, and Buswick 2013). Our own analysis indicates that water and wastewater rate increases have generally outpaced inflation of the Consumer Price Index since 2008, indicating that the charges for water and wastewater service have risen much faster than the rise in other consumer goods. Nonetheless, governing boards of local governments are challenged to balance all rate and tax increases within their control (e.g. water and wastewater rates, property taxes, fees, etc.) and the financial conditions outside of it. In difficult economic times, governing boards may choose to stagger increases to different services over time instead of raising costs to their citizens on multiple fronts. Investor-owned utilities and wholesalers must also stay sensitive to their customers ability to pay. Key Points With worsening economic conditions, many residential and non-residential customers incomes have generally decreased or remained stagnant, while the cost of water and wastewater services has increased. A bad economy, so far, has not resulted in a drastic fall in revenues, but has resulted in much more affordability pressure in many utilities. 93

18 In some cases, declining economic conditions also have direct immediate impacts on revenues, for example, our analysis shows a strong relationship between trends in new home construction and connection charge revenue. Ultimately, utilities across North America operate in very different economic environments with very different pressures. These pressures must be considered in developing business strategies. Trends in Economic Conditions Recent trends in economic indicators likely to influence a utility s operating revenues are shown in Figures Figure 3.13 tracks the unemployment rate of all persons aged 16 or over across the United States and Puerto Rico. Figure 3.14 shows the percentage of people living in poverty between 2000 and Figure 3.15 shows the median household income in the same time period in real terms, adjusted to 2011 dollars. Figure 3.16 shows the change in housing units started across the country and by region between 2000 and In all four graphs, it is clear that socioeconomic and housing conditions have worsened since 2000, and the effects of the recession after 2008 are sharply on display. In Figure 3.13, the national unemployment rate increased from 4.0% in January 2000 to 7.8% in December The national unemployment rate doubled (by five percentage points) during the Great Recession between April 2008 and October While the unemployment rate has declined since then through December 2012, unemployment remained at twice the level it was in January Figure 3.13 Monthly unemployment rate in the United States Among People 16 Years and Over, January 2000 December 2012 This rise in unemployment led to a corresponding rise in poverty and decline in income, as shown in Figures 3.14 and The national poverty rate increased from 11.3% in 2000 to 15.0% in In the seven states that this research focuses on, poverty rates increased in all states, by percentage points during the same time period. 94

19 Figure 3.14 Percent of people in poverty, 2000 to 2011 At the same time, the median household income decreased across the United States and in all seven states since 2000 when adjusted to 2011 dollars, as shown in Figure The nationwide median household income decreased by nearly $5,000 (8.7%) over the eleven year period, with three focus states seeing a decrease of more than $7,500. In other words, more than half of the households in the country made at least $5,000 less in 2011 than in 2000 in terms of real dollars. Thus, households across the country, in general, had decreasing purchase power between 2000 and 2011, while experiencing a 33% increase in consumer prices and an even larger increase in water and wastewater rates post There are regional differences in how the economic conditions affected households. In Figures 3.14 and 3.15, the States of Ohio and Georgia witnessed the greatest decreases in median household income and greatest rises in poverty rates since 2000, whereas the changes in the State of Texas were minor by comparison. There exist also significant differences in socioeconomic conditions between states in 2011 alone, with median household incomes ranging across the seven states between $45,206 in North Carolina and $58,629 in Colorado. Figure 3.15 Median household income in 2011 dollars,

20 Figure 3.16 tracks the number of housing units started across the nation since 2000, as well as in regions of the country. The impact of the recession is most drastically seen in this graph. The U.S. Southern and Western regions experienced the largest decline in housing units started over the twelveyear time period, when housing units started falling by almost 50% in both regions. The Northeast and Mid-west also experienced declines, also to a more modest degree. Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hill and Raftelis Financial Consultants, Inc. Data source: U.S. Census Bureau, Building Permits Data, New Residential Construction Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hill and Raftelis Financial Consultants, Inc. Data source: U.S. Census Bureau, Building Permits Data, New Residential Construction Figure 3.16 Housing Units Started Nationally and By Region, The relationship between changing economic conditions at the local (county) level and the financial performance of combined water and wastewater utilities is demonstrated in Figures Using biennial income statement data from compiled for the national AWWA-RFC Water and Wastewater Rates Surveys, 143 utilities in 41 states with financial data in two separate years at least 4 years apart were identified and used in this analysis. The combined water and wastewater operating revenues was divided by the number of accounts served by the utility in the two years and used to calculate the percent change in average operating revenue per account between the two years. Each utility was matched to a county, and the county s statistics on average annual unemployment rate, poverty rate, and median household income for the equivalent years were obtained from the U.S. Bureau of Labor Statistics and the U.S. Census Bureau. The change in the values of these three local economic indicators between the two years were then computed and graphed against the change in the average operating revenues per account, shown in Figures Each dot represents one of the 143 utilities, and the trend line is added to each graph. No significant correlations were observed in any of the three indicators with changing operating revenues per account, and the trend lines were only very slightly positive (but not statistically significant). In all three graphs, it is clear that the 143 utilities experienced very different changes to economic conditions and operating revenues. Although economic conditions in the United 96

21 States worsened over time, only 39 out of the 143 utilities (27%) experienced a decrease in average operating revenues per account between their two years of analysis, despite decreasing demands, mostly as a result of increased rates. The majority of the utilities, therefore, increased their operating revenues per account over time. In Figure 3.17, 92% of the utilities were in counties that experienced an increase in the local unemployment rate all the way up to a 12.7 percentage point increase for one utility between 2008 and 2012 (City of Yuma, AZ). In Figure 3.17, 92% of the utilities also experienced an increase in the county s poverty rate all the way to a 10.1 percentage point increase between 2004 and 2012 for the City of Ames, IA. In Figure 3.18, 72% of the utilities witnessed the local median household income, in 2012 dollars, decrease in their county. Changes to the counties median household incomes ranged from a decrease of 17.5% between 2006 and 2012 in Waterford, MI and an increase of 14.3% between 2004 and 2012 in New York City, NY. These trends signify that the local economic conditions worsened over time for a large majority of the 143 utilities in 41 states, as expected. With worsening economic conditions, residential and non-residential customers ability to pay for water and wastewater services may have generally decreased. Rate increases allowed three-quarters of the utilities to collect more revenues per account over time, aiding the utilities financial performance and demonstrating that water services in most areas display a certain level of inelasticity. Along with findings in the Trends in Financial Performance (Chapter 2) that total operating revenues also generally increased from 2000 to 2012, these findings imply that the worsening economic conditions of the past decade have not completely eroded utility revenues, as is likely to have occurred in certain sectors during the downturn (e.g. tourism revenues). On the other hand, collecting more revenues per account, while the customers ability-to-pay for services decreases over time, means that utility rates are becoming less affordable. However as shown in Figures , increased unemployment, increased poverty, and decreases in income do not, on their own, equate to utility revenue troubles. However, they do provide insight into the different operating environments facing utilities. Clearly, some areas of the country have customer bases with economic conditions severe enough to potentially impact customers abilities to pay for services, even essential services. Figure 3.17 Changes in average combined water & wastewater operating revenues per account and the county s unemployment rate over at least a 4-year period for 143 utilities nationwide. 97

22 Figure 3.18 Changes in average combined water & wastewater operating revenues per account and the county s poverty rate over at least a 4-year period for 143 utilities nationwide Figure 3.19 Changes in average combined water & wastewater operating revenues per account and the county s median household income over at least a 4-year period for 143 utilities nationwide. Average expenditure for water and/or wastewater services portrayed as a percentage of median household income (MHI) continues to be widely used to provide a snapshot of affordability pressure within a particular community or service area. This metric is only able to present a limited view of household-level challenges. The denominator of the indicator MHI is plagued with shortcomings as an indicatorit masks income distribution within a community and discounts the low-income part of a community curve. A single parent family with two children who makes just over minimum wage will 98

23 earn less than $20,000 per year. These types of distressed families make up a portion of almost every community, regardless of the community s median income. Both a community with an MHI of $75,000 or one with an MHI of $30,000 will experience the same affordability challenge related to this type of low-income family. Addressing the financial impacts of water service on low-wealth families is both a public policy issue and a financial issue; as distressed families have more difficulty paying bills, the amount of late payments and disconnections go up. In addition, as it becomes clear that some families are unable to pay for basic services, the pressure on elected boards to keep rates low for the entire customer base increases. Figure 3.20 shows the evolution of water and wastewater expenditures between 2004 and 2012 using two metrics. The chart on the left shows that almost every utility in the sample asked their customers to pay a greater percent of their income on water services in The data also show that even though the percent of income devoted to water has increased, it still remains below 2% for all of the utilities. The right side of the chart shows the evolution of the percentage of household income a family with an income at poverty threshold pays within the same utility sample. The analysis shows much more significant changes facing low income families with many families that had been paying less than 2% of their income, now paying 3% or higher. Figure 3.20 Comparison of the cost of water as a percent of median household income and as percent of poverty threshold 99

24 Figure 3.20 is based on utilities that participate in the national AWWA-RFC survey and focuses only on water sales. This survey is the most prominent national survey on water pricing and includes many of North America s largest utilities. Other rate surveys carried out at the state level include smaller more rural utilities and provide additional insight on the challenges facing utilities serving very low-income communities. Figure 3.21 shows the two affordability metrics plotted against each other for utilities in the State of North Carolina. The survey also includes both water and wastewater services. The first thing that becomes apparent in this analysis is that many more utilities than in the national survey have customer bases paying a higher percent of their income on water and wastewater. The chart also shines light on potential affordability pressures facing utilities that have a more affluent overall customer base but still area asking their low income customers to pay a sizable component of their income for water and wastewater. Percent $20k Income (Annual Bill / $20,000) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Figure 3.21 Affordability pressures across North Carolina Communities with fewer than 20% hhlds with income less than $20k Communities with 20 39% hhlds with income less than $20k Communities with 40% or more hhlds with income less than $20k 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% Percent MHI (Annual Bill/Median Household Income) Analysis by the Environmental Finance Center at the Unversity of North Carolina, Chapel Hill. Data Sources: NCLM/EFC 2012 NC Water & Wastewater Rate Survey; U.S. Census Bureau year American Community Survey. As shown above, most of the economic challenges over the last decade may be putting pressure on utilities but have not resulted in absolute declines in revenues. At least one economic trend can be seen to have a profound and direct impact on revenues housing declines. After the housing market collapsed in , the number of new homes and buildings built decreased in many cities across the country. New buildings connecting to the water systems traditionally provided utilities with a reliable source of revenues in the form of connection (tap) fees and system development charges or impact fees. As the growth rate of new buildings declined, so too did revenues from these upfront, onetime connection fees. National data on revenues from connection charges were not available in the data sets analyzed. However, ten years of data on wastewater connection fee revenues were available for 120 special districts in California. The growth in the number of new wastewater connections typically match the growth rate of new water connections; as such, trends in wastewater connection fee revenues are used as a surrogate for trends in water connection fee revenues. 100

25 As shown in Figure 3.22, revenues from wastewater connection fees generally increased from FY2001 to FY2008 in California, before sharply declining. The median revenues from wastewater connection fees in FY2010 were 74% lower than the median revenues just two years prior. The interquartile range of revenues in the cohort also decreased significantly since FY2008, declining by 49%-68% in two years. If these trends were similar to trends in declining revenues from water connection fees, utilities that had been relying on new connections as a significant source of revenues each year would have seen these revenues virtually disappear, leaving them with a financial gap in the absence of increased rates. Figure 3.22 Revenues from wastewater connection fees from FY2001 to FY2010 for the same 120 California special district utilities These trends are also noticeable at the utility-level, as shown in Table 3.3. Water (and wastewater) tap fee revenues from seven Colorado utilities declined significantly since between FY2008 and FY2010. As shown by the sparklines, the tap fee revenues decreased by more than half in the span of a few years. Since 2010, the housing market has partially recovered, suggesting that revenues from connection fees and system development charges may be increasing once again. However, national and statewide data are not yet available to verify. 101

26 Utility in Colorado References Table 3.3 Tap fee revenues for seven Colorado utilities, FY2004 FY2010 City of Florence's water tap fee revenues City of Grand Junction Water's water tap fee revenues Buena Vista Sanitation District's sewer tap fee revenues Cherokee Metropolitan District's water & sewer tap fee revenues City of Brighton's water & sewer tap fee revenues City of Broomfield's sewer tap fee revenues City of Fruita's sewer tap fee revenues Chapman, T., J. Breeding and G. Buswick U.S. Municipal Water and Sewer Utilities Face Continued Rate and Drought Pressure in Dallas, Tex.: Standard & Poor s Rating Services. CAPACITY UTILIZATION Introduction One of the most important decisions a utility controls is when and how to expand capacity as their customer demands evolve with time. Typically, as demand grows and water production or transmission nears the capacity of a utility s system, facilities are expanded to meet anticipated demands far into the future. Immediately after the major expansion of a critical facility such as a treatment plant, the system will likely have underutilized capacity for years to come. The larger the treatment plant expansion, the greater the initial cost, but the longer it takes before additional expansions are required. Utilities that are nearing capacity have several alternatives including: installing new capacity that will serve them for many years to come; investing in conservation programs to extend existing capacity; and/or sharing unused capacity from nearby utilities. The threat of running out of capacity typically dominates the decision process for many utilities despite the financial cost of underutilized capacity. For most, the political impact of failing to meet demand is far greater than the financial cost. Key Points Tap fee revenues FY2003- FY2010 Percent change in tap fee revenues from previous Fiscal Year FY'04 '05 '06 '07 '08 '09 '10 Data analyzed by the EnvironmentalFinance Center at the University of North Carolina, Chapel Hill and Raftelis Financial Consultants, Inc. Data Source: Colorado Water Resources andpowerdevelopment Authority. Bars reflect the percent change to annual revenues from tap fees from previous fiscal year. Dark bars are relative gains, light bars are relative losses. The y axis scalesare unique for each utility. Utility capacity (as measured as a function of water treatment plant capacity utilization) varies significantly among individual utilities; the majority of utilities use 50-80% of their capacity on a maximum day. No clear, direct relationships appeared between capacity utilization and rates of return on equity, but more in-depth analysis is expected to reveal a detrimental financial impact with building capacity necessary to meet overestimated demands. 102

27 Utilization rates influence what types of management practices utilities can employ to improve their financial position. Assessing Capacity Utilization In an effort to explore the relationship between capacity utilization and financial performance, two different data sets of self-reported information on water utilities treatment capacity, daily usage, pricing, and financial performance were used. The first dataset comes from a biennial survey of North American utilities conducted by the American Water Works Association (AWWA) and Raftelis Financial Consultants, Inc. (RFC) and includes information from 570 utilities throughout the United States and Canada for the years from 2000 through The second data set comes from the State of North Carolina s Local Water Supply Plans (LWSP). These plans are submitted to the state s Department of Environment and Natural Resources by all local government-owned and all large community water systems in the State and contain information on their water sources, sales, and treatment plants. These data sets were merged with utility rate data from the North Carolina League of Municipalities (NCLM) and the Environmental Finance Center at the University of North Carolina (EFC) annual rates surveys and financial reports from the North Carolina Office of the State Treasurer. Unfortunately, data were not available to factor in excess capacity in the pumping and distribution system. Capacity Utilization Trends The water treatment plant capacity for utilities participating in the AWWA-RFC survey was assessed against systems average and maximum days 2. Using AWWA-RFC figures for 2012, the median average day sales as a percent of capacity was 38%. The median maximum day sales as a percent of capacity were 68%. The full distribution, shown in the Figure 3.23, shows the majority of utilities between 20-40% capacity utilities on an average day and between 50-80% capacity utilization on a maximum day. Utilities with treatment facilities in North Carolina followed a similar distribution. 2 This analysis also revealed an underlying challenge in working with self-reported data. A small subset (less than 5%) of utilities responding to the AWWA-RFC survey reported maximum and, in some cases, average-day water usage that was significantly higher than their plant capacity. Though the survey asks for max-day water production and daily water treatment production capacity, it seems clear that many utilities responded with figures that reflected more than just what is happening at their treatment plant. For example, one utility in California reported that it had a daily production capacity of 24 million gallons, but that it produced 44 million gallons on its peak day in The utility s operating statistics for fiscal year show, by contrast, that it actually has a combined treatment plant capacity of only 9 million gallons daily. Water purchases from another utility make up the bulk of its remaining source of drinking water. This underlying ambiguity in the AWWA-RFC survey response inhibits the ability to produce more extensive analyses from some utilities capacity utilization estimates. 103

28 Figure 3.23 Plant capacity utilization in 2012 of 251 water utilities Across North America Over the past twelve years, the AWWA-RFC survey sample reports minimal changes in average day capacity utilization. As shown in Figure 3.24, utilities responding to the survey in 2000 reported median average-day capacity use of 41%. That figure rose to 42% in 2002 and again in 2006 before declining to a median average-day capacity utilization of 38% in Figure 3.24 Average day capacity utilization from for water utilities across North America 104

29 While the median capacity utilization rate across the sample has stayed relatively steady, individual utilities have seen more pronounced trends. Figure 3.25 shows the trend for the sub-group of 25 utilities that responded to each of the seven AWWA-RFC surveys. Those utilities experienced regular increases in their plant capacity (approximately 15% over the 12-year period), even though their average and maximum day use fell by an average of approximately 10% during the same timeframe. In other words, these 25 utilities expanded their treatment plant capacities during a time when their total demands were actually decreasing. Financially, this likely placed additional burdens on the utilities and their customers to pay for the new capital costs and associated higher operating and maintenance costs, while collecting lower revenues as customers use less water. Figure 3.25 Change in plant capacity and water use over time for 25 utilities Relationship Between Treatment Plant Capacity Utilization and Utility Financial Condition But to what extent do these trends impact the actual financial condition of a utility? To provide an initial take on this question, utilization rates were studied against water charges and a financial indicator; the results used to discuss the various finance and management options available to utilities in different circumstances. Capacity utilization was plotted against the household charge at a standardized consumption level to detect if utilities with underutilized capacity have higher charges than their peers. Additionally, capacity utilization was also plotted against a utility s return on assets (operating revenues divided by total assets) to assess the financial efficiency of operating at a higher capacity. Ultimately, neither of these methods provided conclusive results on the direct relationship between capacity utilization and charges or financial performance, but rather suggests a more complex relationship between external drivers and strategies that can be engaged for utilities at either end of the spectrum. 105

30 Household charge When examined in isolation, water treatment plant capacity utilization did not have a direct relationship with household charge (as shown in Figures 3.26 and 3.27). In other words, utilities with lower or higher plant capacity utilization did not necessarily have predictable lower or higher rates. Each figure plots a calculation of capacity utilization on a system s maximum day (National utilities, Figure 3.26) and a system s average day (North Carolina utilities, Figure 3.27). Even though, there is no clear trend between capacity utilization and the absolute charge at one consumption point, these graphs do allude to differences in system characteristics and pricing challenges and opportunities for utilities. For example, the utility in Figure 3.26 that has low maximum-day capacity utilization but relatively high water charges should hope to sell wholesale water to a neighboring community or experience rapid community growth to cover the costs of this capacity. Meanwhile, a utility with high water charges and high capacity utilization may have proactively increased rates to cash-finance a portion of the high capacity. $80 $70 Water Charge at 10ccf $60 $50 $40 $30 $20 $10 $ Maximum Day Capacity Utilization Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hilll. Water charge represents either year round rates or the average of high and low season rates. Data source: Financial and operating data compiled by Raftelis Financial Consultants. Figure 3.26 Water charge at 10 ccf and maximum day capacity utilization in 2012 for 241 National utilities 106

31 $120 Water Charge at 7,000 Gallons $100 $80 $60 $40 $20 $0 Figure 3.27 Water charge at 7,000 gallons and average day capacity utilization in 2011 for 176 North Carolina utilities Return on Assets Average Day Capacity Utilization Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hilll. Data source: UNC EFC Water and Sewer rates surveys and NC Department of Environment and Natural Resources Local Water Supply Planning data. Despite the fact that utilities are monopolies, theoretically, a system that is optimizing its capacity should be generating a higher return on those assets than a utility with underutilized capacity. Figures 3.28 and 3.29 show that utilities with higher capacity use on both the maximum and average day did tend to have slightly higher returns, but there is still a great deal of variation in the data, indicating that a number of other factors are playing into a utility s return on its assets (operating revenue divided by total assets). Return on Assets Maximum day Capacity Utilization Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hilll. Data source: Financial and operating data compiled by Raftelis Financial Consultants. Figure 3.28 Return on assets and maximum day capacity utilization in 2012 for 212 national water utilities 107

32 Return on Assets Figure 3.29 Return on assets and average-day capacity utilization for 176 North Carolina water utilities in 2011 Implications Average Day Capacity Utilization Data analyzed by the Environmental Finance Center at the University of North Carolina, Chapel Hilll. Data source: NC Local Government Commission financial data and NC Department of Environment and Natural Resources Local Water Supply Planning data. This research provides at best marginal evidence that utility plant capacity utilization directly affects utility finances. Despite a slight general trend, there is a great deal of variation in the relationship between capacity utilization and rates, as well as capacity utilization and return on equity. Nevertheless, two factors may be obscuring the relationship. First, there is some concern that many utilities in the AWWA-RFC data set were reporting their water usage and total source water (including water purchased from other utilities) rather than the production capacity and daily usage of the treatment plant itself. Second, capacity utilization is not a static management decision but is, instead, a strategic plan for growth and expansion. Much of the fluctuation in utility finances and capacity use is a simple result of the timing of expansions in capital infrastructure. As a result, certain relationships that exist when a large portion of plant infrastructure goes unused for years at a time may not appear in data that primarily reflect utilities decisions about when they should expand their plants to handle new growth. It is also worth noting that these results do not imply that plant capacity decisions never have an effect on utility finances. In fact, though average impacts throughout the data sets may be small, there are certainly instances in which decisions about capital projects can make a dramatic difference in a utility s financial health. Consider, for example, the experience of the Orange Water and Sewer Authority (OWASA) in Orange County, North Carolina during the years 2000 to Based on a steady growth trend since the 1970s, the utility undertook a multi-million dollar upgrade and expansion of its wastewater treatment facilities. Unfortunately, just after funding this expansion, the utility saw a dramatic decrease in water demand during a record drought in and concurrent implementation of a new seasonal rate conservation pricing structure. Even after the drought was over, demand did not recover, and expected growth did not occur due to the economic downtown. Current statistics show that demand in 2012 was at about the same level as demand in 1990, despite about a 108

33 60% increase in the number of customer accounts that OWASA serves. As a result, the expanded wastewater treatment capacity was not as necessary as originally anticipated, and OWASA s current capital improvements plan indicates that the utility expects to have no need to expand its wastewater treatment plant further until at least OWASA s falling demand is also visible in AWWA-RFC data on water production capacity, which show that the utility s average day demand was 53% of its water treatment plant capacity in 2000, but only 34% of capacity by Following a significant debt issuance in 2004, primarily to fund the upgrade and expansion of the wastewater treatment plant, OWASA s debt to asset ratio increased to 48%. (It has since declined to a current ratio of 30% as the cost of debt-funded assets has been capitalized.) Despite this anecdote, industry-wide trends reveal no consistent pattern between capacity trends and utility finances. The experience of OWASA demonstrates that unfortunate timing of plant capacity expansions coinciding with decreasing demands can lead to financial constraints. and upward pressure on rates. More in-depth research that uses standardized and validated data could more easily parse out the actual financial impact of overbuilding capacity to meet overestimated demands. Additionally, utilization rates influence what types of management practices utilities can employ to improve their financial position. Utilities with excess unused capacity have an incentive to sell more water to current customers and/or to minimize future sales reductions. On the other hand, utilities with relatively little excess capacity and are at the other end of the capacity utilization cycle have an opportunity incorporate and benefit from reduced demand rates. The stakes in maintaining excess capacity should be seen as a significant financial risk and potential burden to utility customers particularly in a period of declining or flat sales. Furthermore, and perhaps most importantly, the incremental costs of carrying excess capacity may erode the ability of a utility to invest in rehabilitation and other non-capacity expansion needs. ECONOMIC REGULATION AND GOVERNANCE Introduction While many utilities have considerable flexibility and freedom to design their pricing model and implement a wide range of locally customized rates and fiscal policies, for some, there are critical economic regulatory and governance factors that influence fiscal condition and the practices and strategies for improving it. In most cases, the degree to which a particular utility is regulated in a state depends on the state, the type of utility ownership, and service area characteristics. For example, in most states, investor-owned utilities fall under the jurisdiction and economic regulatory influence of a public service or utility commission. In some states, governmental utilities with particular governance structures or service area attributes are regulated. For example, in the State of Maine, governmental public service districts that provide service in multiple jurisdictions are closely regulated by the Maine Public Service Commission, whereas a city-owned system that serves customers within a single city is controlled by the city council (Maine Revised Statutes 1987). Historically, protecting consumers from the adverse impacts of monopolistic practices has driven economic regulation in North America (Beecher 1997), however some of the emerging pricing regulation can be attributed to more general public policy goals. For example, a few state and regional entities prone to drought or water shortages have begun incorporating pricing guidelines or requirements into their environmental regulations and policies. They are profiled below. The scope of what is covered by an economic regulatory system varies and may include review and approval of rate modifications, review and approval of significant capital investments, control of specific pricing decisions, or general oversight of financial health. 109

34 This section profiles several different economic regulatory models to illustrate the potential pricing and financial resiliency impact of economic regulation and governance systems. Our analysis focused on North American approaches, however it is important to point out that this is an area of utility management that has been studied extensively overseas (Beecher 1997). For example, the United Kingdom s water management culture is founded on a national economic regulatory system and regulator (Office of Water, aka OFWAT) that has been the target of study for years and is quite different from the prevailing models found in North America. Water utilities in the United States fall under varying types of ownership and management: state and federal government agencies, tribes, municipalities, counties, districts, authorities, not-forprofit water associations, investor-owned water companies, international and national corporations, individuals, homeowner associations, and more. By October 2012, the 50,803 active community water systems in the United States were nearly evenly split between those owned by local governments (48%) and those owned by private organizations (47%) (USEPA 2012). The varying organizational structures create different incentives, opportunities, and challenges for managing utilities finances. Understanding the characteristics of each organizational structure is therefore essential for a holistic theory of utility financial health. In this section, several broad types of governance ownership and economic regulatory structures are analyzed ranging from city utility departments to investor-owned utilities. While the discussion below of each type of organizational structure is general, in nature, individual distinctions are rampant. Water utilities that are owned by individuals, homeowner associations, state or federal agencies, and tribes are excluded from this discussion since they represent a very small minority of water systems that set rates and directly charge customers for water service. Key Points Governance and economic regulatory models can take different forms at varying levels across the country, depending on the state and system type. The economic regulatory framework guiding a utility can have a major influence in the types of financial practices it can implement. Areas with economic regulators have very different pricing modification trends than those that are locally regulated. Economic regulation alone does not necessarily guarantee financial strength or resilience. Public policies, such as monopoly protection and water resource management, influence financial resilience and limit pricing strategies. At a high level, organizational structures do not seem to have a direct influence on rate setting or financial performance negatively or positively. However, a more comprehensive analysis of rate setting trends and financial performance may detect more targeted differences between these various types of utilities. Future research should more comprehensively study the intended and unintended financial ramifications of external utility economic regulation and governance model structures. 110

35 Municipal/County-Owned Utilities Utilities owned and operated by a municipality or county experience significant political and financial integration with the broader local government. Public utilities are often set up as a separate department in the city or county government, with a director and staff, and, many times, as a dedicated enterprise fund solely for the water and/or wastewater utility. While most municipal/county-owned utilities may have a stated goal of being financially independent, transfers between the government s general fund (both in and out) are common and provide an interdependence that does not exist for other utility models. Although water and wastewater utilities are normally managed independently of other local government functions, the governing body of the utility is typically the same group of (usually elected) officials who oversee all other local government functions. While staff typically manage the finances of the water utility, they normally must seek approval of the city council or county commissioners for rate increases and for adjusting certain financial policies. It is important to point out that the council/commissioners are typically also responsible for voting on financial decisions for the police or sheriff s department, public works, parks and recreation, etc. The competing demands of managing the budgets spanning numerous government functions means that the governing body will have less time to devote specifically to managing water utility finances. These conditions may increase disincentives for some governing bodies to raise water rates or approve expensive capital projects. On the other hand, being ultimately and publicly responsible for the water utility, the threat of being voted out of office for mismanagement incentivizes the governing body members to make prudent financial decisions when necessary. There are varying degrees of this model that range from a utility as a government executive department that is treated as a municipal department for government purposes (i.e. directly compete for General Fund dollars) to a government agency that reports to an independent governing board appointed by the mayor and approved by the City Council or Board of County Commissioners (Seidenstat 2003), with a few options in between. Independent Authorities and Districts The later model mentioned above (independent board reporting to City or Council) moves the organization of a water system much closer to the structure of an independent authority or district. Local government utilities may be formed independently of municipalities and counties, representing a middle ground between local government ownership and private corporations. California has led the country in the use of municipal utility districts (Seidenstat 2003). These independent authorities or districts are special units of local government set up with the single purpose of providing water and/or wastewater services in a regional area that may or may not transcend municipal/county/state boundaries. Since they are independent of municipal and county governments, they operate without the possibility of transfers in from or out to a government General Fund and are less likely to have broad taxation authority. These utilities typically also have separate governing boards whose sole purpose is to manage the utility and whose attention will therefore be undivided. The makeup, structure, and powers of the governing boards vary across different types of independent authorities and districts. In many cases, the governing board members are appointed to their positions, limiting the influence of elections on their decision-making. Private Investor-Owned Companies Private companies have a greater degree of financial and political independence compared to governmental structures, though they face different incentives and challenges associated with investor ownership. Investor-owned utilities seeking sustainable and predictable profits have a financial incentive to raise rates and lower costs to maximize profits for their investors, but are also almost 111

36 always financially regulated by a Utilities Commission in order to ensure a reasonable but not excessive rate of return on investments. One of the project s utility partners, Aqua North Carolina, is an investor-owned utility that is part of the national company - Aqua America. The North Carolina Utilities Commission oversees and regulates rate setting and financial practices for Aqua (NC), as well as other investor-owned water utilities. As is the case in many but not all states, North Carolina s Utility Commission has no authority or influence over rate setting and finances of government-owned water utilities. Aqua (NC) serves 250,000 residents in 53 counties from 796 separate water systems (Aqua 2013). The concept of separate water system refers to a Federal environmental regulatory framework that is often very different than the economic regulatory framework. Aqua (NC) is considered to manage nearly 800 separate systems because the systems are not physically connected, have different sources of water, and subsequently, different Public Water identification numbers under state and federal law. However, from an economic regulation perspective, Aqua NC is one system under shared management. This is important, because Aqua s pricing strategy, which it believes is a key to its financial resilience, is based on a uniform tariff or consolidated rate approach throughout the vast majority of its service area. In other words, a customer served by a groundwater system in the western part of the state pays generally the same rates as a customer served by a larger surface water system in the central part of the state. The ability for an economically regulated utility to implement this pricing strategy, as well as other pricing strategies, such as allowing decoupling or surcharges, to recover unexpected expenses is controlled by utility commissions in most states. One of the most important impacts of investor-owned water utility regulation is to encourage the concept of full cost pricing where rates are set to cover all of the eligible costs of operating a water system, as well as a rate of return to shareholders. There are often disagreements about what constitutes reasonable costs and rate of return on invested capital, but the economic regulatory framework is founded on having utilities fully cover operating as well as capital costs. Self-regulated governmental water utilities, such as those regulated by city or county boards, may have rates that do not cover all of the financial costs (e.g. depreciation) of utility operation choosing instead to transfer money from the general fund to make the utility financially whole or even to operate the system at a loss. Investor-owned utilities do not have that option in the long-term. Another important impact of the investor-owned regulation model relates to the ability of utilities to fund and maintain reserve funds. Non-regulated utilities may determine that revenue stability and/or future capital needs justify raising rates in the short-run to fund reserve funds to benefit financial resiliency long- run. In almost every state 3, investor- owned utilities set rates based on historic costs and cannot raise rates solely to fund reserve funds. Government-Owned Utilities Regulated by a Utility Commission Commonly, government-owned utility finances are regulated almost exclusively by their governing board. In fact, only three out of 45 states in the United States comprehensively regulate public water systems at the state level: Maine, West Virginia, and Wisconsin (Beecher et al. 1994). In these states, governmental utilities have to follow prescribed rate adjustment processes that influence when and how they can modify rates. The impact of this type of regulatory framework can be quite 3 According to the 1993/1994 NRRI Survey on State Commission of Water Utilities, the Michigan Public Service Commission is the only State Commission that allows rate stabilization reserves. 112

37 pronounced. The Wisconsin Public Service Commission regulates rates, large construction projects, utility finance, regional water supply solutions, rules and practices, and legal compliance for all government-owned water utilities (WI PSC 2013). This report discusses rate adjustment history across six different states. As Wisconsin is the only state in the group that comprehensively regulates government-owned utilities, the analysis suggests that this type of regulation influences utility rate setting and financial performance. Figure 3.30 below compares the frequency of rate adjustments in five consecutive years. The analysis shows a much higher percentage of utilities in Wisconsin did not change rates or changed them only once over the past five years, as compared to the other states. Figure 3.30 Frequency of rate adjustments in five consecutive years for six states This has the potential to lead to larger rate increases, as shown in Figure 3.30 With the exception of California (see Prop 218 discussion below), average rate adjustments are higher (sometimes significantly) for utilities that change rates only once in five years. In Wisconsin, for example, utilities that increased their rates only once in the five year period had rate increases approximately five times larger than those of utilities that increased their rates on a yearly or almost yearly basis (Figure 3.31). Similarly, utilities that changed their rates nearly every year had a significantly lower average rate adjustment. This trend is similar (if not as pronounced) in NC, OH, TX, and GA. 113

38 Figure 3.31 Average rate adjustment by frequency The stark difference between rate adjustment trends in Wisconsin compared to the other states does not necessarily indicate financial insufficiency, but it can. Figure 3.32 compares the non-capital operating ratios utilities in Ohio, Texas, and Wisconsin. (The other three states included depreciation in their operating expenses and so cannot be compared at the same level.) Although the analysis shows that the majority of Wisconsin utilities have operating ratios higher than 1.0 (i.e. they are collecting enough revenues to cover the operations and maintenance of their system), between 12% and 26% of utilities, in any given fiscal year, collected less operating revenues than operating expenses (i.e. operating ratio less than 1.0). Under this type of situation, these utilities would have to use their reserves, transfers and/or non-operating revenues to fill the gap between day-to-day operations and maintenance expenditures and their operating revenues, leaving little to no revenue to cover capital expenses. Figure 3.32 Non-capital operating ratios 1 among the same 1,236 utilities in OH, TX, and WI over time 114

39 Other Types of Economic Regulation and Oversight Interestingly, the data from Ohio and Texas speak to another type of water utility economic regulation that occurs at the state level outside of utility commissions. The ratios computed in Ohio and Texas were for utilities that had outstanding loans with the Ohio Water Development Agency and the Texas Water Development Board, respectively. These utilities have their financial data reviewed, analyzed, and monitored by these two agencies, which work to ensure that the utilities are in strong financial position to pay back their outstanding debts. State governments have other mechanisms to oversee the financial health of water systems in their jurisdiction. Over recent years, there has been increasing attention given to the fiscal health and sustainability of local governments in many areas of the country. 4 While many state governments may have ultimate responsibility for backstopping troubled local governments, some states such as North Carolina, maintain strong on-going financial oversight of local government utilities that directly impacts fiscal policies and pricing. From within the Office of the NC State Treasurer, the Local Government Commission (LGC) assures local governments are managed in a fiscally responsible manner. The LGC requires submittals of audited financial statements from all governmental utilities and reviews and analyzes financial condition on an annual basis. Local governments exhibiting evidence of financial hardship, as indicated by metrics such as operating margin and days-of-cash-onhand, are often required to implement corrective actions in the form of rate increases or other financial policies. The LGC must also approve all debt and include a detailed analysis of utility financials. This oversight is one of the factors cited by rating agencies as contributing to the large number of highly rated local government issuers in the state (NC State Treasurer 2013). Regulated utilities are not the only utilities in some states that are subject to state law governing certain aspects of rate setting. State law can play a major role in rate setting for all utilities. For example, several of the project s partner utilities are based in California and must comply with California rate setting legal limitations, such as Proposition 218. Prop 218 (as it is referred to by most local governments and utilities) was passed as a ballot initiative in 1996 and resulted in an amendment to the California Constitution that required changes in property-oriented charges to be subject to the vote of the people. Water rate increases have been deemed to be covered by Prop 218 and as a result, utility customers are presented with an opportunity to vote against a proposed rate increase. In theory this creates an external economic regulator beyond a utility governing board, however relatively few utilities have seen their rate proposals over-turned as a result. This is possibly because water customers that do not vote (in most cases by mail in ballot) are considered as non-opposing votes. Nonetheless, the mere presence of this possibility appears to influence rate setting and put additional pressure on utilities to balance public opinion with concern for financial stability. For example, although more frequent rate increases may lead to a stronger finance position, they also require more political capital. Figure 3.31 shows a different rate setting trend in California, as compared to the other states. California was the only state where not one utility changed rates every year. Conversely, it was also the only state where every utility changed rates at least once during the study period. California was also the only state whose utilities rebuked the trend that more frequent rate increases come at smaller increments. Figure 3.31 indicates that the utilities that increased rates only once increased rates at a lower percentage than those that occasionally changed rates. Although not 4 At the time this report was being written, the State of Michigan was finalizing taking control over the City of Detroit (Davey 2013) 115

40 conclusive, this seems to suggest that Prop 218 may be rewarding utilities with higher rate increase that stay in front of the public regarding revenue needs. Another impact Prop 218 has on pricing relates to the constitutional requirement it created for proportionality among rate payers. It formalized and codified the principle that a rate payer pays their proportional cost of service and thereby limits any clear cases of cross subsidization among customer classes (League of California Cities 2007). The result is that California utilities are unable to charge some customers higher rates in order to generate funds to lower the rates of others or to directly fund an affordability assistance program. In some states and regions of the country, regulations and guidelines designed to promote environmental and water resource management public policy goals have begun to incorporate elements of pricing regulation. Some of these environmentally-oriented pricing measures take the form of general guidelines and sometimes they include very specific requirements. For example, HB 2499, a comprehensive drought and water conservation bill passed in NC in 2008 identified pricing as a specific conservation measure (NCDENR 2013). The bill introduced both the concept of rates adequate to cover capital costs, as well as rate structures that promote water conservation. More specifically, the Metropolitan North Georgia Water Planning District requires all utilities in the 15 county, 90+ city region utilities in the district to adopt increasing block rate structures that encourage conservation by charging higher rates for customers with higher water use. Without an increasing block rate structure for residential customers, a local government will not be able to receive a permit for increased water withdraws (MNGWPD 2013). Even more specifically, the California Urban Water Conservation Council creates a voluntary framework for conservation that utilities are encouraged to sign on to but which are very formulaic as follows: Total Annual Revenue from Volumetric Rates (V) 70% V+ Total Annual Revenue from Customer Meter/Service (fixed) charges Direct Impact on Financial Condition While the governance and economic structures discussed above have a clear impact on financial policies, the numerous other factors influencing financial condition make it difficult to determine the extent to which economic regulation drives financial performance. There is little evidence from the national AWWA-RFC Water and Wastewater Rates Surveys and the North Carolina and Georgia rates surveys that organizational structures have had a significant impact on the financial performance of utilities, but this sample is limited. For example, the median operating ratios of 263 utilities nationwide in the 2012 AWWA-RFC Water and Wastewater Rates Survey do not vary significantly by organizational structure, as shown in Figure The median operating ratio (operating revenues / operating expenses) was only slightly higher for independent districts and authorities than for municipal and county-owned utilities, but the interquartile range of operating ratios was lower. This dataset produced an operating ratio estimate for only one privately-owned utility, negating any comparison between investor-owned utilities and the other two forms of utility ownership described in this section using this dataset. 116

41 Figure 3.33 Operating ratios by system ownership for 263 utilities nationwide in 2012 At the state level, data compiled from financial statements collected by the North Carolina Local Government Commission show that average operating revenues increased steadily between FY1997 and FY2010 for municipal utilities, county-owned utilities, and special units of governments (i.e.: independent authorities and districts) (Figure 3.34). The average operating revenues and the rate by which they rose over time were very similar for the three types of local government utilities, again revealing no significant differences by ownership structures. Figure 3.34 Average annual operating revenues in North Carolina by organizational structure, FY1997 FY

42 Combining data from the North Carolina and Georgia rates surveys reveals small differences in the price of water based on organizational structures. As shown in Figure 3.35 independent authorities and districts had, on the median, consistently higher marginal prices than non-profits and municipal/county-owned utilities, but there are many possible reasons for this difference in addition to governance structure. For example, authorities and districts often serve larger less dense geographic areas than city systems. Further, the rate at which the median marginal prices rose over time was greater for independent authorities and districts than it was for municipal/county-owned utilities. These results may imply that governing boards of independent authorities and non-profits were, on the median, more comfortable setting and raising higher volumetric rates for water service than the city councils and county commissioners were in these two states. Figure 3.35 Median water marginal price for next 1,000 gallons at 5,000 gallons/month for 650 North Carolina and Georgia utilities by organizational structure, Overall, given the lack of empirical evidence that organization structures influence rate setting or financial performance on a grand scale, it is likely that organizational structures may affect utilities individually but not positively or negatively across the board. However, a more comprehensive analysis of rate setting trends and financial performance may detect more targeted differences between these various types of utilities. Future research should more comprehensively study the intended and unintended financial ramifications of external utility economic regulation. 118

43 References Aqua North Carolina Service Territory. [Online]. Available: < [cited April 15, 2013] Beecher, J.A., P. Mann, Y. Hegazy, and J. Stanford Revenue Effects of Water Conservation and Conservation Pricing: Issues and Practices. Columbus, Ohio: The National Regulatory Research Institute at Ohio State University. Beecher, J. A Water Utility Privatization and Regulation: Lessons from the Global Experiment. Water International, 22(1): Davey, M Michigan Naming Fiscal Manager to Help Detroit. The New York Times, March 1, [Online]. Available: < [cited: May 9, 2013] League of California Cities Proposition 218 Implementation Guide. Sacramento, Calif.: League of California Cities. Maine Revised Statutes Title 35-A: Public Utilities Heading, Chapter 21: Organization, Powers, Service Territory Heading, Organization of certain public utilities. [Online]. Available: < < [cited May 9, 2013]. MNGWPD (Metropolitan North Georgia Water Planning District) Water Supply and Water Conservation Management Plan. Atlanta, Ga.: Metro Water District Board. [Online]. Available: < [cited April 15, 2013] NC State Treasurer Information on State and Local Government: Local Government Commission. [Online]. Available: < Commission.aspx> [cited April 15, 2013] NCDENR (North Carolina Department of Environment and Natural Resources) Drought Bill Signed Into Law. [Online] Available: < [cited April 15, 2013] Seidenstat, P Organizing Water and Wastewater Industries to Meet the Challenges of the 21st Century. Public Administration and Management: An Interactive Journal, 8(2): USEPA (United States Environmental Protection Agency) October 2012 data in Safe Drinking Water Information System Database. [Online]. Available: SDWISFED Drinking Water Data. < [cited April 18, 2013] WI PSC (Public Service Commission of Wisconsin) Information on the State s water industry regulation. [Online]. Available: < [cited April 15, 2013] FINANCIAL MANAGEMENT STRATEGIES Introduction As with other business enterprises, many utilities striving for performance improvement adopt one or more integrated management theories, programs, or initiatives to guide their decision-making. A study of 15 different management initiatives carried out in 2004 concluded that creating an integrated management framework can lead to a greater chance of performance improvement than implementing discrete independent management practices (Integrated Management Systems Design Team 2004). Adopting a comprehensive approach to management can also help utilities rally around specific performance goals and create a shared institutional resolve to make difficult decisions. Management 119

44 philosophies and systems can vary quite a bit; however, many of these business strategies include similar components relating to finance and revenue stability. There are a number of integrated management theories utilized by water and wastewater utilities. These include Effective Utility Management (EUM), Lean, Six Sigma, and Total Quality Management (TQM). These techniques can be used alone or in concert to further utility financial and management goals. The Resource Guide to Effective Utility Management and Lean explains that EUM helps utilities to assess their strengths and weaknesses, prioritize their goals, and determine what outcomes the utility wants to achieve, while Lean and Six Sigma are business improvement approaches that focus on eliminating non-value added activity and help utilities to reach the desired outcomes. Several utilities have effectively incorporated the concepts of EUM and Lean into their longterm strategies. This section of the report highlights the manner in which both of these management strategies address utility finances directly and highlights a case where the combination of the two had a direct financial impact. Key Points Among other attributes, current management strategies in the industry, such as Effective Utility Management and LEAN, advance financial management. The extent to which each and any management strategy has measurable impact on the financial condition and revenue resiliency of a utility could be the exclusive focus of an entire report. Focus on Effective Utility Management as a Financial Management Driver Since its inception, EUM has become more comprehensive, and is now serving as a framework to help utility executives, governance boards, policy-makers, and regulators improve utility performance in a number of areas (AWWA 2008). The framework allows for planning, implementation, measuring, and monitoring performance enhancements against the Ten Attributes, which include: Product Quality; Customer Satisfaction; Employee and Leadership Development; Operational Optimization; Financial Viability; Infrastructure Stability; Operational Resiliency; Community Sustainability; Water Resource Adequacy; and Stakeholder Understanding and Support. Specifically focusing on Financial Viability, EUM cites well-managed utilities as: understanding the full life-cycle costs of the utility and establishing and maintaining an effective balance between long-term debt, asset value, operations and maintenance expenditures, and operating revenues. Downward pressures on revenue due to falling sales and traditional pricing model has made maintaining this balance difficult for many utilities. The EUM Primer goes on to discuss the importance of establishing predictable rates to adequately cover costs, meet community expectations, provide for reserves, maintain support from bond rating agencies, and plan and invest for future needs. Metrics associated with financial viability include budget management effectiveness: debt ratio, 120

45 revenue to expenditure ratio, O&M expenditures or capital expenditures, etc. While many of the tenets of Effective Utility Management have been widely recognized by utilities, a highly branded and endorsed framework may provide managers and boards facing difficult decisions with additional momentum to achieve financial resiliency. Focus on LEAN as a Financial Management Driver As previously mentioned, LEAN refers to a set of principles and methods focused on the systematic elimination of non-value added activity. The principles and methods started with Toyota, in the manufacturing sector, and have since spread to diverse industries and sectors around the world. The idea is that people learn to see where inefficiency in resource use and deployment exists. This is often used in conjunction with Six Sigma, which is a statistical process that identifies process variation to improve overall quality. Specifically relating to improving the financial state of utilities, LEAN offers several methods that help to ensure that resources are being used in the most effective way possible. For example, LEAN Events are two-five day periods where cross-functional teams of employees will analyze and improve a process. Six Sigma can also help to find and eliminate process variation, which can result in significant cost savings. Utilities adopt LEAN to: Achieve better financial and operational results; Enhance customer service; Produce quality products and services; Optimize operational and administrative processes; Reduce risks and errors; and Improve staff morale and engage employees. According to the Resource Guide to Effective Utility Management and Lean, One of the most frequently cited benefits of LEAN is cost savings, which maps to the Financial Viability Attribute in the EUM system. Cost savings and cost avoidance are realized from process changes that allow utilities to avoid investing in costly new controls and increase machinery and process efficiency (USEPA 2012). Utility Case Study City of Pompano Beach Utilities The City of Pompano Beach Utilities Department (Department) serves approximately 80,000 customers in Pompano Beach, Florida. The Department has used both an EUM assessment and LEAN process-improvement tools to develop an action plan to move improvement activities forward. As a result, the Department has seen significant operational and management results, including increased water efficiency, improved customer satisfaction, and enhanced financial viability. The Department started the improvement process with the help of a consulting group, which facilitated the EUM assessment. Based on the assessment findings, the highest priority areas for the Department were Product Quality, Financial Viability, Infrastructure Stability, Operational Optimization, and Employee and Leadership Development. The first task was then to create groups to focus on safety and job performance standards, and to systematically evaluate the processes in place and identify where failures might occur, so that process improvement could occur. The Department used a variety of LEAN and Six Sigma techniques to achieve the targets identified in the EUM assessment. 121

46 One particular problem that the assessment found and LEAN helped to solve was the ICanWater Reuse Connection Program, which had seen low customer base penetration through By using the Six Sigma Define-Measure-Analyze-Improve-Control method, the Department was able to increase reuse connections from an average of 1.5 per month to more than 270 between October 2011 and April 2012, with an additional 770 planned by July This increase in reuse water addressed several of the attributes identified in the EUM assessment, including Financial Viability, by reducing pressure on drinking water supply and the need for expensive system upgrades (Oasis Reuse Water Utilities 2013). The extent to which each and any management strategy has measurable impact on the financial condition and revenue resiliency of a utility could be the exclusive focus of an entire report. Most likely, more influential than the strategy itself is the manner in which it is applied. Suffice it to say an integrated management strategy, like Effective Utility Management and LEAN, drive integrated decision-making and prioritization which many studies have shown as a best practice in financial management. References AWWA (American Water Works Association) Effective Utility Management: A Primer for Water and Wastewater Utilities. Denver, Colo.: AWWA. [Online]. Available: < [cited May 9, 2013] Integrated Management Systems Design Team Continual Improvement in Utility Management: A Framework for Integration. Washington, D.C.: USEPA, Association of Metropolitan Sewerage Agencies, and Water Environment Federation. [Online]. Available: < [cited May 9, 2013] Oasis Water Reuse Utilities I Can Water. Pompano Beach City, Fla.: Oasis Reuse Water Utilities. [Online]. Available: < > [cited May 9, 2012] USEPA (United States Environmental Protection Agency) Resource Guide to Effective Utility Management and Lean: Improving Performance and Addressing Key Management Priorities at Water-Sector Utilities. Washington D.C.: USEPA. [Online]. Available: < [cited May 9, 2013] CREDIT RATING AGENCIES Introduction Water utilities considering, or in the process of, issuing debt through the capital markets often decide to request a credit rating of that utility s debt from one or more rating agencies, Standard & Poor s, Moody s, and Fitch Ratings. The rating is designed to provide information to prospective investors/lenders and influence utility access to, and the cost of, borrowing money. Fundamentally, each credit rating agency assesses the ability and willingness of an entity to repay impending debt issuance on-time and in-full, given the entity s financial and operating circumstances. However, each credit agency focuses on slightly different qualitative and quantitative indicators to evaluate a utility s credit strength. In addition to individual utility ratings, rating agencies produce periodic sector reports and analyses that provide a wealth of general industry financial condition and trend information (summarized in Table 3.1). Individual utility reports, assessments, and special reports serve as an external third party reflection of the financial position of individual utilities and the industry as a whole. For many utilities, these external assessments also serve as important financial drivers and benchmarks behind internal financial policies and rate decisions. 122

47 Key Points Credit rating agencies weigh a myriad of qualitative and quantitative considerations when determining credit ratings; there is no pre-set formula for a good rating. Ultimately, credit rating agencies are looking for flexibility, capacity, and predictability. Although the individual and summary reports from credit rating agencies provide a reflection of the financial condition of the water industry, the processes engaged by credit rating agencies are also driving the financial priorities in the industry. Traditionally, credit rating agencies view water demand as revenue, although there is some movement to recognize long-term, cost-effective conservation and efficiency efforts. The industry is challenged to account for triple-bottom line strategies due to scope and accounting limitations. Reflection of Financial Position of Individual Water Utilities and the Industry as a Whole In general, credit rating agencies collect data on and evaluate the credit worthiness of the country s largest utilities because these utilities are primarily the entities issuing debt. At varying degrees of frequency, each credit rating agency releases their rating criteria a summary of the multitude of qualitative and quantitative factors each agency considers when assigning a certain rating to an entity (summarized in Table 3.4). 123

48 Agency Fitch Ratings Standard & Poor s Moody s Research and Ratings Other Players Rating criteria US Water and Sewer Revenue Bond Criteria (7/13) Standard & Poor s Public Finance Criteria (2008) Analytical Framework For Water And Sewer System Ratings (8/1999) Table 3.4 Summary of Credit Rating Agency Guidance Recent assessments and special Ratings reports system 2013 Water and Sewer Medians (12/5/12) 2013 Outlook: Water and Sewer Sector (12/5/12) Sector Review: Funding Long- Term Needs Remains The Biggest Risk For U.S. Municipal Water And Sewer Utilities (1/31/12) How U.S. Municipal Water And Sewer Bond Ratings Correlate With Some Key Measures Of Issuers Credit Quality (9/26/2011) UK Water Sector Outlook 2011 Industry Outlook (10/2011) AAA AA (avg) A+, A BBB +,- AAA AA A+/(median)- BBB +,- Aaa Aa A Bb 1,2,3 Number of Water and Wastewater Utilities Rated Approximately 400 Approximately 1,300 Approximately 800 The credit rating agencies are not the only entities collecting and evaluating the financial performance and trends of the industry. Prudent public lenders, like the United States Department of Agriculture and state government loan programs, including the Environmental Protection Agency/State Revolving Loan Funds, as well as private lenders are evaluating the financial viability of the agencies they fund. In many cases, public sector and private capital lenders incorporate hard financial targets in loan agreements, while in other cases lenders monitor performance less formally. In addition, regulators such as public service and utility commissions evaluate and regulate the financial performance of the utilities in their state. There are also a host of research, professional, and technical assistance organizations that promote the measurement and monitoring of financial performance and management strategies for the betterment of the industry. The financial metrics used and propagated by each of these organizations have significant overlap. The list below summarizes an example of a Best Practice advocated by one key organization, the Government Finance Officers Association (GFOA), for determining appropriate levels of working capital in enterprise funds. Many of the following considerations coincide with the metrics used by rating agencies. 124

49 GFOA s Primary considerations when customizing a working capital target for public enterprise funds Support from general government Transfers out Cash cycles (i.e. peaks and valleys in in-flow) Customer concentration Demand for services Control over rates and revenue Asset age and condition Volatility of expenses Control over expenses Management plan for working capital Separate targets for operating and capital needs Debt position No Formulas, Just Considerations Much as the GFOA s considerations in the list above include a mix of objective and subjective indicators, the ratings agencies each use a number of quantitative and qualitative financial health metrics to prepare a utility s financial profile and associated bond rating. As part of the project, specific ratings of utilities were studied, particularly for those utilities serving as partners on the project, as well as recent general guidance and criteria documents, to summarize the credit raters perspectives on revenue resilience. The finding: there is not a single pre-set formula for solid financial footing and a high credit rating. In fact, some of the metrics are in direct conflict with one another. For example, an excerpt of Standard & Poor s ratings (summarized in Figure 3.36) highlight the importance that rating agency places on a history of rate increases, while at the same time recognizing the need for competitive and affordable rates. 125

50 Periodically, Fitch Rating s releases a report on Water and Sewer Revenue Bond Rating Criteria the explains in detail each criterion used by the agency to evaluate a utility s credit worthiness, as well as provides an evaluation of stronger, mid-range, and weaker financial profiles. Although Fitch Ratings take into account many more quantitative metrics, they have also identified a list of key metrics summarized in the following table (Table 3.5). Table 3.5 Fitch Rating s Key Financial Ratios (Scott et al. 2013) Metric Definition Significance Total outstanding longterm debt per customer Total outstanding longterm debt per capita Projected debt per customer Projected debt per capita Three-year historical average senior lien annual debt service (ADS) coverage Three-year historical average all-in ADS coverage Total amount of utility long-term debt divided by the total number of utility customers (for a combined utility, the aggregate number of water and wastewater accounts are used) Total amount of utility long-term debt divided by total population served by the utility Total projected outstanding system debt (existing debt less scheduled amortization plus planned issuances) divided by total outstanding projected customers for five years from the date of the rating Total projected outstanding system debt (existing debt less scheduled amortization plus planned issuances) divided by total projected population served by utility (population is inflated based on anticipated growth) Most recent three-year historical average of annual revenues available for debt service coverage divided by respective senior lien debt service for the year Most recent three-year historical average of annual revenues available for debt service divided by respective total debt service for the year Indicates the existing debt burden attributable to ratepayers (principal only) Indicates the existing debt burden attributable to each person served by the utility (principal only) Indicates the total debt burden to ratepayers five years from the date of the rating (principal only) Indicates the total debt burden to each person served by the utility five years from the date of the rating (principal only) Indicates the financial margin to meet current senior lien ADS with current revenues available for debt service Indicates historical trend in total ADS coverage (continued) 126

51 Table 3.5 (Continued) Metric Definition Significance All-in ADS coverage Current-year revenues available for debt service divided by current-year total debt service Indicates the financial margin to meet current total ADS with current revenues available for Minimum projected all-in ADS coverage Days cash on hand Days of working capital Free cash as a % of depreciation Minimum debt service coverage projected typically over the ensuing five-year period, based on revenues available for debt service in any given fiscal year, divided by the respective total debt service amount for that fiscal year Current unrestricted cash and investments plus any restricted cash and investments (if available for general system purposes), divided by operating expenditures minus depreciation, divided by 365 Current unrestricted assets plus any restricted cash and investments (if available for general system purposes), minus current liabilities payable from unrestricted assets, divided by operating expenditures minus depreciation, divided by 365 Current surplus revenues after payment of operating expenses, debt service, and operating transfers out divided by current year depreciation debt service Indicates the financial margin during the year in which future total ADS coverage is projected to be the lowest Indicates financial flexibility to pay near-term obligations Indicates financial flexibility to pay near-term obligations Indicates annual financial capacity to maintain facilities at current level of service from existing cash flows Standard & Poor s and Moody s have similar lists of metrics they purport as critical to their credit ratings, but each credit rating agency may weigh these factors slightly different resulting in rating level variance between the three. In addition to measuring a utility s ability to meet its operating and debt expenses under normal and slightly altered conditions, rating agencies stress the importance of metrics that gauge economic capacity (household/per capita effective buying income as a percentage of U.S. level), revenue diversity (top ten customers as a percentage of total operating revenues), and off-balance sheet fixed financial obligations. In their criteria documents, both S&P and Fitch Ratings stress that quantitative metrics and ratios cannot completely portray the financial condition of a utility (Standard & Poor s 2007; Scott et al. 2013). Economic, management, structural, and other qualitative factors may be given equal, if not more weight when assessing an entity s ability and will to meet its financial obligations. Fitch Ratings has coined the phrase 10 C s to alliterate its portfolio of considerations including: community characteristics, customer growth and concentration, capacity, compliance with environmental laws and 127

52 regulations, capital demands and debt policies, covenants, charges and rate affordability, coverage and financial performance, cash and balance sheet considerations, and crew. Figure 3.36 Key credit rating considerations of S&P for 18 drinking water utilities from The word cloud above identifies analyses trends among a group of Standard & Poor s ratings for 18 of our utility partners prepared between 2010 and (The larger a word or phrase, the more often it was cited.) In most cases, we ve stripped the considerations of non-quantified adjectives like strong, steady, and aggressive to draw attention to common themes and considerations. (It s important to note that in the analysis above each utility received an AA or AAA rating from S&P.) Some prominent rating concerns like service area (Is the customer base large and diverse, or small and concentrated?) and customer wealth are outside the control of utility officials. Credit raters also consider income levels, housing values, employment patterns, and population growth. However, many of the recurring concerns (such as financial coverage and rate increase history) fall under the direct influence of utility management. Furthermore, the credit rating agencies are analyzing a utility s preparation and response to the factors outside of its control, with a focus on flexibility, capacity, and predictability. Financial Focus on Flexibility, Capacity, and Predictability In addition to hitting different variations of key debt service coverage ratios, Fitch Ratings and Standard and Poor s place high value on utilities whose day-to-day operations are relatively free from political interference (Scott et al. 2013) and utilities that display rate flexibility ; that is, they are willing and able to increase rates as necessary to cover costs (Dyson 2011). In a 2012 report, Moody s discusses this willingness as a combination between the flexibility and capacity of organizations to manage rates and costs (Medina et al. 2012). In general, credit rating agencies define a resilient utility as one that has revenue and resource flexibility, capacity, and predictability. Of course, these attributes are also important when assessing costs as well. The following excerpts from credit rating summaries 128

53 highlight areas where flexibility, capacity, and predictability were addressed in general guidance or specific summaries from credit rating agencies. Flexibility As monopolies, governance structure and pricing strategy largely govern the flexibility of a utility. Credit rating agencies are looking for evidence of a utility s will to utilize this flexibility. To Increase Rates. Credit rating agencies are assessing whether or not political leaders and utility officials have, and will, raise rates. Alameda, CA. The district has historically raised rates annually, which has led to increased operating revenue over time and has offset some of the effects of conservation in recent years. (Hannay and Dyson 2012). AAA/Stable Austin, TX. City officials have demonstrated their willingness to raise rates (Chapman and Murphy 2011). AA/Stable Metropolitan Water District, CA. On April 10, 2012, the district's board voted to increase rates by an average of 5.0% in each of the next two calendar years, 2013 and The 2013 increase is less than what district staff had proposed (7.5%) but more than the district's most vocal critics wanted (0-3%). This 5% compromise position, which keeps the cost of "wholesale supplies as low as possible" according to the district's board chairman, raises the specter that the district's previous above-average willingness to raise rates when necessary may be weakening in the face of increasingly vocal criticism. While we recognize the rhetorical appeal and inherent vagueness of keeping rates "as low as possible," in the long-run such rates will not maintain the district's long-term credit quality at a level consistent with its current rating. (Moody s Investors Service 2012) Aa1 Fort Worth, TX. The downgrade reflects weak financial performance stemming from the city's lack of willingness to raise rates in the current fiscal year to offset reduced water sales. Given this unwillingness, Fitch is concerned that the city may be reluctant to implement the magnitude of rate increases needed to regain historical margins. (Seebach and Wenck 2013) AA To Absorb Temporary Financial Shocks. Reserves are commonly cited as a financial positive because they allow a utility to absorb temporary financial shocks, such as those caused by the implementation of watering restrictions in response to an unexpected water shortage. The number of days-of-cash on hand that a utility has indicates how long it could operate with absolutely no new revenue. This report discusses the use of reserve funds as a strategy for revenue resiliency in great detail. Despite placing high value on the existence of these reserves, Standard & Poor s cautions against the reliance on reserves, as they provide a limited amount of additional security and are sometimes used as a political backdoor to making unsustainable financial decisions (Chapman 2012d). Alameda, CA. The district s liquidity position is strong, in our view (Unrestricted cash and investments represent 610 days of operating expenses) (Hannay and Dyson 2012). AAA/Stable Daphne, AL. Although the board may draw down unrestricted cash and investments from 458 days of operational expenses, one of the board s financial principles is to 129

54 maintain unrestricted cash equal to at least 120 days expenditures (Sagen and Waite 2012). AA-/Stable Glendale, CA- The negative outlook reflects our view that if unrestricted cash remains near $0 during the next two years as debt service and debt levels increase, we will likely lower the rating. In the nearer term, we believe the currently high debt service coverage (3.5x) and the ability of the water fund to borrow from the electric fund provide the water system some financial flexibility (Chapman and Hannay 2011). AA/Negative From Environmental Regulation. Credit rating summaries typically view and discuss regulation as a driver of capital costs outside utility control that can compromise a utility s ability to increase rates and cover costs. External regulations, government intervention, or scrutiny over affordability can limit an issuer s ability to direct their own operations (Medina et al. 2012) Jackson, MS. The sewer system is under a state order from the Mississippi Commission on Environmental Quality (MCEQ) to address sewer overflow and sludge violations.. Although consent decree requirements will likely allow the city multiple years to address identified sewer issues, the capital costs are expected to be large and could total as much as $600 million. The city's ability to handle this amount of capital requirements given the lack of rate-raising history and financial / capital planning is reflected in the negative outlook..we will continue to monitor the outcome of the consent decree and management's ability to plan for and manage the expectedly large capital requirements. (Moody s Investors Service 2011) Aa1 Atlanta, GA. Although the city council s resolution reiterates its commitment to comply with consent orders and current rate increases, in our opinion, the internal audit requirement together with management s efforts to obtain an extension on meeting consent order milestones based on affordability guidelines signals increased rate sensitivity. (Breeding and Sugden-Castillo 2011) A/Stable Capacity To Increase Rates. Credit rating agencies are assessing how high a utilities rates are by comparing its rates are to those in surrounding areas and similar utilities. Low rates, when considered in the context of service area income levels, indicate a capacity to increase rates. If a utility is deemed to have high rates, affordability pressures may arise that could significantly decrease a utility s capacity to increase rates. Credit ratings take into consideration capital improvement plans (CIPs) and approaches large CIPs with caution weighed very heavily against the capacity of the utility to increase rates. Austin, TX. Despite rate increases, the $71 residential bill for 8,000 gallons of combined service is especially competitive because of the water supply agreements already in place (Chapman and Murphy 2011). AA/Stable Raleigh, NC. Management has demonstrated a willingness to adjust rates.despite annual increases, the system s rates are still affordable relative to service area wealth levels. We expect management to continue to adjust rates as needed (Pezzimenti and Costa 2012). AAA/Stable Fort Worth, TX. The combined water and sewer monthly bill of $62.46 (assuming usage of 7,500 gallons per month for both water and sewer) equals a moderate 1.5% of median household income, providing the system sufficient rate flexibility. (Seebach and Wenck 2013) AA 130

55 To Meet Demand. Credit rating agencies are also viewing capital and resource plans of utilities to evaluate their capacity to meet demand. Demand equals revenue. In general, if a utility does not have the capacity to meet demand, it means lost revenue. The following excerpts provide insight into direct considerations of this relationship. Metropolitan Water District, CA. In dealing with short-term water shortages, like drought, Standard & Poor s praised the Metropolitan Water District of Southern California for engaging effective drought policies to match demand to supply. MWD implemented a 10% reduction in water available to customers in 2009 due to drought and reaffirmed it in April However, they built up storage capacity to fill up when conditions are wet so that they can sell water during drought (Dyson and Hannay 2011). AAA/Stable Daphne, AL. The system s diverse customer base is still growing, albeit at, what we consider, a more-moderate pace; system treatment capacity adequately meets current demands. (Sagen and Waite 2012) AA-/Stable Atlanta, GA. According to the Atlanta Journal Constitution (AJC), local governments in metro area Atlanta received a report from the credit agency Fitch Ratings, warning that their credit scores may be downgraded depending on the outcome of a federal lawsuit over access to drinking water from Lake Lanier. According to AJC, Fitch warned that water will continue to be a primary rating driver, given the devastating effect any material reduction would have on the region (Joyner 2011). In late spring 2012, the 11th Circuit Court of Appeals upheld Atlanta s right to draw its drinking water supply from Lake Lanier, thus forestalling its water and credit woes for the near future. Predictability In addition, credit rating agencies take into account decision-making and financial arrangements between a utility and its governing body. Obviously, the governance structure of a utility and established contracts fall out of the exclusive control of utility management, but the credit rating agencies are also assessing the process and predictability of the arrangement. For example, S&P does not necessarily view a transfer from a public enterprise fund to the general fund of the governing body as a negative factor, as long as the transfer policy is well-researched, flexible, consistent, and wellcommunicated (Standard & Poor s 2007). How a utility reacts, or better yet, anticipates its operating environment largely factors into its rating. Water Demand Historically, credit rating agencies cite aggressive conservation programs as weaknesses because they have a direct and immediate impact on operating revenue. In 2011, Standard & Poor s noted that the City of Austin, Texas financial metrics would have looked stronger, if it weren t for the City s aggressive water conservation and resource management program (Chapman and Murphy 2011). Meanwhile, Fitch Ratings recognized those utilities that were able to meet rising consumptive demand without significant usage restrictions (Scott et al. 2011). When assessing whether or not a drought will impact a utility s credit rating, Fitch Ratings identified the following factors (summarized in Table 3.6). This Water Research Foundation report contains discussion and financial strategies around many of the factors that are under management s control. 131

56 Table 3.6 Drought-time credit considerations by Fitch Ratings and assessment of utility control Fitch Ratings factors (Scott et. al 2011) Is this factor under management s control Current drought stage No Current and anticipated drought restrictions Somewhat Level of precipitation needed to end drought Somewhat restrictions compared to historical precipitation amounts Current actions to avoid water shortage and Somewhat availability of alternative supplies Current and anticipated effect of drought on demand, Somewhat revenues, and expenses Current actions to mitigate the drought s effect on Yes utility financial performance Degree of revenue certainty from base charges Yes relative to budgeted revenues Usage assumption used in current budget Yes Anticipated actions to ensure financial health should Yes drought continue Lasting effects of drought on supply costs, customer No demand, etc. In coping with present and future water shortages, credit rating agencies seem to be beginning to recognize that while conservation efforts can impact revenues and financial risk profiles (fixedcharge coverage ratio is negatively impacted by conservation and wet weather) in the short-term, such efforts are necessary to deal with long-term risks associated with supply shortages and high costs of capital (Chapman 2012b; Leurig 2012). In their guidance reports for utilities, there is consensus that financially prudent utilities will account for the long-term benefits of conservation and long-range planning, including deferred costs of capital via demand reduction, incremental decreases in operating costs (such as electricity for pumping and water treatment chemicals), and ability to manage risks associated with seasonal water use variability (Chapman 2012d; Scott et al. 2013). Pricing and Rate Structures Drought and seasonal variability are closely related to a utility s revenue resiliency because of pricing and rate structures. In 2012, Standard & Poor s recognized that although the Alameda Water District s operating revenue had experienced the effect of conservation in recent years, some of these effects were mitigated by annual rate increases and therefore retained their AAA/Stable rating by the agency (Hannay and Dyson 2012). And while the rating agency rebuked the City of Austin, Texas for its aggressive water conservation and resource management programs, they praised the utility for its plans to update its business model by adding a fixed revenue stability fee (Chapman and Murphy 2011). Fitch Ratings views favorably a utility whose fixed portion (base charge) of the water and wastewater bill makes up greater than 30% of the total bill (Scott et al. 2013), although it is not currently reported on its median report. This later point alludes to the regard for fixed revenue over variable revenue by credit rating agencies and the lending institutions on whose behalf they work. Revenue that is dependent on discretionary water use can compromise a utility s financial health when faced with drought 132

57 restrictions in the short-term and its credit rating soon thereafter (Leurig 2012). However, the credit rating agencies, and in fact many utilities themselves, stop short of discussing the degree of vulnerability posed by the design of certain rate structures. The Cart Leading the Horse: The Driving Power of Credit Rating Financial Metrics Up until this point, credit rating agencies and the metrics they use have been discussed as a reflection of an individual or group of utility s financial performance. However, there is a management adage that suggests what gets measured, gets done. In 1954, Peter Drucker published a book entitled The Practice of Management that suggests that if people are accountable to a certain metric, they will forsake other non-measured efforts to meet or succeed the measured effort. Given that credit rating agencies are probably the most influential financial surveyors of the industry, the metrics they use, at least in a small part, set the bar against which utilities develop their own financial policies. But credit rating agencies guide the financial policies by more than just defining the metrics. In fact, certain ratings have become the overarching goal of the financial policies set by utilities. For example, Charlotte-Mecklenburg Utilities Department s financial policy stresses the importance of maintaining a AAA bond rating from the three credit rating agencies, according to an interview with CMUD director, Barry Gullet (Gullet 2012). The utility set its financial performance goals by benchmarking against other AAA rated utilities and consulting with financial advisors. Charlotte-Mecklenburg Utilities is not alone. Others in our utility cohort had similar guidance set forth in their financial policies as summarized below: Denver Water s debt guidelines state the organization s desire to maintain the standalone revenue bond rating at a level of AA or better. (Denver Water 2012) Objective A: Maintain AAA 7-year financial goals and meet appropriated designated fund level goals. (Mesa Waterer 2011) Credit rating is one of the performance measures tracked by the Office of the General Manager at the Metropolitan Water District of Southern California. The intent of the measurement is to enable Metropolitan to access capital markets at the lowest borrowing cost. The target is set at AA, Aa2 or better. (Metropolitan Water District of Southern California 2010) Maintain WaterOne s current Bond ratings for senior debt of AAA from S&P and Aaa from Moody s. (Water District No. 1 of Johnson County 2012) The [Clayton County Water] Authority s primary objectives [of its debt policies] are to minimize debt service and issuance costs; maintain access to cost-effective borrowing; achieve the highest practical credit rating; ensure full and timely repayment of debt; maintain full and complete financial disclosure and reporting; and ensure compliance with applicable state and federal laws. (Clayton County Water Authority 2011) Clayton County Water Authority s open-ended objective of achieving the highest practical credit rating indicates that there are some costs associated with achieving the highest credit rating. Future analysis should look into just what these costs and benefits are. According to the Director of Charlotte-Mecklenburg Utilities, maintaining AAA bond rating means more to his utility than a lower interest rate, it ensures that the utility (and City) have access to the market when they need it, so that both can maintain liquidity (Gullet 2012). For many utilities, a lower interest rate can lead to substantial cost savings on bond repayments. Figure 3.37 shows the differences in the interest rates for 20 th year maturity by credit rating grade. 133

58 Interest rates for credit ratings Aa, A, and Baa remain fairly widespread over time; however, prior to 2008 the spreads were generally less than 0.3% and are now consistently over 0.5%. Figure Municipal market interest rates for 20 th year maturity by credit rating (WM Financial Strategies 2013) Table 3.7 shows the differences bond debt for an Aa rated utility, and a Baa rated utility for a $40,000,000 bond for interest rates in 2009 and After one year at the 2009 interest rate, there is a one million dollar difference in interest owed. At the 2013 rate however, this difference drops to $460,000 (WM Financial 2013). Thus, it is clear that a utility s credit rating can have a significant financial impact, but how do those financial benefits compare to the costs of maintaining very high debt service coverage ratios and reserves that need to go largely untouched? Future research is needed to weigh the true costs and benefits of certain credit ratings. Table 3.7 Cost savings from interest rate differences due to credit rating Interest Principal + Interest Rate Interest Rate After 1 year (at (2009) 1 (2013) rate) Principal + Interest After 1 year (at 2013 rate) Credit Principal Rating $40,000,000 AA $41,960,000 $41,100,000 $40,000,000 BAA $42,960,000 $41,560,000 Cost Savings in 1 year: $1,000,000 $460,000 1 Interest Rates calculated from Figure

59 Conclusion and Gap Analysis If indeed the credit rating agencies are steering the financial decisions of some of nation s largest utilities, where are they taking the industry? Are there unintended consequences of the quantitative and qualitative guidance explicitly and inexplicitly communicated through individual utility credit ratings? Scope and accounting limitations Credit rating agencies are ultimately beholden to the lenders, not to water customers, in their assessment of utility financial health. And lenders are concerned about the financial health for the tenure of the debt: 20, 10, 5 years or less. As such, credit rating agencies are short-sighted in their ability to integrate innovations in water utility infrastructure into their ratings systems, specifically those designed to address the triple bottom line. For example, at this point, the key agencies have not devised a methodology for assessing a utility s green infrastructure or low impact development assets, such as cisterns. In this paradox of innovation and proven reliability between the utilities and the ratings agencies, up to this point, utilities have a limited ability to accurately convey information about the financial and environmental advantages of investments into innovative practices or to demonstrate the value of such practices relative to comparable utilities (Augustyn, Leurig, and Odefey 2012). A growing number of cities are meeting regulatory standards and cutting costs by installing green infrastructure. Yet some organizations such as American Rivers argue that there is a lack of credible valuation or accounting for natural infrastructure or other ecosystems services (American Rivers et al. 2012). Additionally, ratings agencies, industry groups, and policy makers use four main financial metrics to identify investment and physical asset replacement: operating ratio (Bernstein 1993), age of plant (Hessenthaler, Masterson, and Quiroga 2008), fixed asset turnover (Bhattacharya 1995), and infrastructure condition (Garvin 2003). However, the financial statements and accounting behind these metrics are founded on recording assets at their historic or book value the value, in nominal dollars, at which assets were purchased. This convention, combined with the common approach to depreciation of assets (straight-line depreciation) leads to some distortions between the economic value of the assets and the value reported on the annual financial statements (Ratcliffe and Munter 1981). Another impact of this accounting system is that utility accounting systems remain unable to attribute value to natural assets that provide water storage, filtration, and delivery. This makes it difficult to include such assets on a utility s balance sheet, or to finance the acquisition or development of these assets on the bond market (Hughes 2009). As an example, over the next 13 years, Seattle Public Utilities estimates it will spend about $500 million on capital construction projects including retrofits, green infrastructure, and large underground storage tanks. Through these green investments, the utility estimates it will save approximately $375 million in future operating and maintenance costs over 13 years (SPU 2012). How the city will account for the value and depreciation of these assets, which are decentralized in nature and may not be owned by the city (i.e. green roofs, parking lot bio swales), continues to vex utility financial staff. Credit ratings agencies general outlook on innovations in green infrastructure and technology adoption is that utilities financial risk is reduced only at the point where the innovation is proven reliable and effective at meeting regulatory and service requirements at a utility-wide scale (Chapman 2012c). The sector has yet to develop a uniform methodology to account for unconventional water quality and conservation infrastructure in their asset portfolios. Nonetheless, they currently serve as good resource and driving force behind the financial performance of many of the nation s water utilities. 135

60 References American Rivers, Ceres and The Johnson Foundation Charting New Waters: Financing Sustainable Water Infrastructure. Racine, Wis.: The Johnson Foundation at Wingspread. Augustyn, F., S. Leurig, and J. Odefey Restoring Flows : Financing the Next Generation of Water Systems. Washington, D.C.: Ceres and American Rivers. Bernstein, L.A Financial Statement Analysis : Theory, Application, and Interpretation. 6th ed. Boston, Mass.: Irwin/McGraw-Hill. Bhattacharya, H Total Management by Ratios: An Integrated Approach. New Dehli, India: Sage Publications. Chapman, T. 2012a. Dry as a Bone: The Drought Spurs Municipally-Owned Utilities to Rethink Their Long-Term Plans and Funding. Dallas, Tex.: Standard & Poor's Ratings Services. Chapman, T. 2012b. From Droughts to Conservation: Water Can Have Big Effects on U.S. Municipal Utility Credit Quality. Standard & Poor's Credit Week, March 7. Chapman, Theodore. 2012c. Interview by Christine Boyle. Telephone. Chapel Hill, N.C., September 5 th, Chapman, T. 2012d. U.S. Municipal Water and Sewer Utilities: Funding Long-Term Needs Remains Their Biggest Risk. Standard & Poor's Credit Week, March 7. Clayton County Water Authority. Clayton County Water Authority Authority Law and Policy Manual. Morrow, Ga.: Clayton County Water Authority. Denver Water Denver Water 2012 Budget: Summary of Financial Policies. Denver, Colo.: Denver Water. [Online]. Available: < A26C-B6A2EE661B764088/BudgetBook2012.pdf> [cited May 1, 2013] Drucker, P.F The Practice of Management. New York, N.Y.: Harper & Row. Dyson, P Global Credit Portal: Metropolitan Water District of Southern California; Water/Sewer. San Francisco, Calif.: Standard & Poor s. Garvin, M.J Strategic Characterization of Water System Infrastructure and Management. New York, N.Y.: Columbia University Press. Gullet, Barry Interview by author. Telephone. June 15, Hessenthaler, S.D., K. Masterson and G. Quiroga Median Ratios for Water and Sewer Revenue Bonds. New York, N.Y.: Retail Systems. Hughes, S Beyond the Operating Ratio: Using Financial Statement Analysis to Assess Fixed Capital Investments. Chapel Hill, N.C.: University of North Carolina. Joyner, C Water Wars Threaten Credit of Metro Government. The Atlanta Journal-Constitution, June 3. [Online] Available: < [cited on May 1, 2013]. Leurig, S Water Ripples: Expanding Risks for U.S. Water Providers. Boston, Mass.: Ceres. Mesa Water Mesa Consolidated Water District Strategic Plan. Costa Mesa, Calif.: Mesa Water District (Mesa Water). Medina, J., J. Aingorn, K. Krummenacker, M. Matesanz, D. Aschenbach, C. M. Hu and J. Hempstead US Public Infrastructure: Slow Economic Recovery Tests Willingness to Manage Rates and Costs, October 23. New York, N.Y.: Moody s Investors Service. Metropolitan Water District of Southern California Biennial Budget for Fiscal Years 2011/12 and 2012/13. Los Angeles, Calif.: Metropolitan Water District of Southern California. NC Urban Water Consortium Analysis conducted on utility residential billing records for NC Urban Water Consortium. Chapel Hill, N.C.: Environmental Finance Center. Ratcliffe, T. and Munter, P Complete Handbook of Inflation Accounting. Englewood Cliffs, N.J.: Prentice-Hall, Inc. 136

61 Scott, D., G. Gutierrez, J. Seebach, and T. Wenck Fitch Ratings Special Report: Texas-Sized Drought for the Lone Star State. New York, N.Y.: Fitch Ratings. Scott, D., K. Masterson, A. Booker, and A. DeStefano US Water and Sewer Revenue Bond Rating Criteria. New York, N.Y.: Fitch Ratings. SPU (Seattle Public Utilities) Adopted Budget. Seattle, Wash.: SPU. [Online]. Available: < nsportation.pdf> [cited on May 21, 2013] Standard & Poor s Public Finance Criteria: Financial Management Assessment. New York, N.Y.: McGraw-Hill. Standard & Poor s Credit Research Dry As a Bone: The Drought Spurs Municipally-Owned Utilities to Rethink Their Long-Term Plans and Funding. Cited in Leurig, S Water Ripples: Expanding Risks for U.S. Water Providers. A Ceres Report. [Online]. Available: < [cited May 1, 2013] Water District No. 1 of Johnson County Budget 2012: Fiscal Policies & Procedures. Lenexa, Kan.: Water District No.1 of Johnson County. WM Financial Rates Over Time: Interest Rate Trends. [Online]. Available: < [cited May 1, 2013] Credit Ratings Breeding, J. and J. Sugden-Castillo. July Atlanta, Georgia; Water/Sewer Rating for Standard & Poor s. Long Term Rating: A(SPUR)/Stable. Dallas, Tex: Standard & Poor s. Chapman, T. and R. Hannay. July Glendale, California; Water/Sewer Rating for Standard & Poor s. Long Term Rating: AA(SPUR)/Negative. San Francisco, Calif.: Standard & Poor s. Chapman, T. and P. Murphy. November Austin, Texas; Water/Sewer Rating for Standard & Poor s. Long Term Rating: AA/Stable. Dallas, Tex: Standard & Poor s. Dyson, P. and R. Hannay. August Metropolitan Water District of Southern California Rating for Standard & Poor s. Long Term Rating: AAA/Stable. San Francisco, Calif.: Standard & Poor s. Hannay, R. and P. Dyson. January Alameda County Water District Financing Authority, California Alameda County Water District; Water/Sewer Rating for Standard & Poor s. Long Term Rating: AAA/Stable. Unenhanced Rating: AAA(SPUR)/Stable. San Francisco, Calif.: Standard & Poor s. Moody s Investors Service. February Moody s assigns Aa1 rating to Metropolitan Water District of Southern California s Water Revenue Refunding Bonds. New York, N.Y.: Moody s Investor Services, Inc. [Online]. Available: < > [cited May 1, 2013] Moody s Investors Service. August Moody s downgrades City of Jackson s (MS) Water and Sewer Revenue Debt to Aa3 from Aa2; assigns Aa3 rating to series 2011A and 2011B Revenue Debt issuances; Outlook is Negative. New York, N.Y.: Moody s Investors Services, Inc. [Online]. Available: < D=19087> [cited May 1, 2013] Pezzimenti, J. and P. Costa. March Raleigh, North Carolina: Water/Sewer Rating for Standard & Poor s. Long Term Rating: AAA/Stable. New York, N.Y.: Standard & Poor s. Sagen, S. and J. Waite. February Daphne Utilities Board, Alabama; Combined Utility Rating for Standard & Poor s. Long Term Rating: AA-/Stable. Dallas, Tex: Standard & Poor s. 137

62 Seebach, J. and T. Wenck. April Fitch Ratings downgrades its rating on the following Fort Worth, Texas (the city) outstanding revenue bonds: --$530.7 million water and sewer system (the system) revenue bonds to 'AA' from 'AA+'. Austin, Tex: Standard & Poor s. 138